Paul Krugman Does S = I + (S-I)

Via JKH in the comments:

“Paul Krugman does:

S = I + (S – I)

The blue line = S

The red line = I

The gap between the blue line and the red line = (S – I)

Oh, yeah … and I’m pretty sure he knows what the definition of saving is.

Anybody ever see a neat graph like this in MMT land?

I.e. one that actually includes I?”

About

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering asset management, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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Dan M.
4 years 6 months ago

WTF, I’m still cloudy on “saving” and “investment”:

If I take out a loan to go on Vacation, does the monetary system measure that as “investing” since a horizontal transaction took place?

If I have a factory built with cash, is the financial sector going to miss that as “investing” because I didn’t go into debt?

I think this site has to give us a more “For Dummies” run down on the domestic private sector S & I… everyone tends to get X-M and G-T, but S-I is a little fuzzy

My main confusion is what seems to be the improper assignigning of the term “Investment” to any credit-expanding private-sector activity, and igonoring activities that don’t expand credit.

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JKH
4 years 6 months ago

“WTF, I’m still cloudy on “saving” and “investment””

They are the standard economic definitions. Some may suggest they should be changed, but we’re not assuming or recommending that.

“If I take out a loan to go on Vacation, does the monetary system measure that as “investing” since a horizontal transaction took place?”

No. That’s consumption. Horizontal can fund either investment or consumption.

“If I have a factory built with cash, is the financial sector going to miss that as “investing” because I didn’t go into debt?”

No. It’s still represented in the horizontal system, because the starting point was a corporate cash asset and an equity claim liability. Both of those are financial assets held by the corporation and its shareholders respectively. The cash was then used to make a real investment, which would have created income payments to factors of production, etc.

“My main confusion is what seems to be the improper assigning the term “Investment” to any credit-expanding private-sector activity, and ignoring activities that don’t expand credit.”

That’s not done here. Households can fund investment directly from saving (e.g. real estate), which is not credit expanding. Corporations can fund investment from saving (retained earnings), which is not credit expanding, although it does result in a corporate sector net financial liability as part of the horizontal nexus, offset by a household sector net financial asset (claim on book value of the stock). Conversely, credit expanding activity can fund consumption as well as investment.

Guest
4 years 6 months ago

@JKH: “Households can fund investment directly from saving (e.g. real estate), ”

Don’t you mean residence-building/remodeling? RE/land purchases aren’t treated as investment, rather more like financial-asset purchases.

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JKH
4 years 6 months ago

Mostly new housing – the value of new residential real estate recorded in the GDP accounts is an investment flow that becomes part of the total residential housing stock.

Overall, the residential housing stock is a real investment (stock) component of household assets, marked to market, which when combined with household NFA (and maybe some relatively minor additional pieces of additional household investment stock) equates to cumulative household saving, marked to market.

Trade in existing homes is conceptually part of the flow of funds, not macro level saving.

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Joseph Laliberté
4 years 6 months ago

JKH:
Corporations do not fund investment with retained earnings. In your last paragraph you may want to say that they fund investment with internally generated cash. Also, this stock of internally generated cash is not saving, but rather more akin to past operating cash flow minus past capital expenditures, or (S-I) in stock form.

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JKH
4 years 6 months ago
Thanks. We’re probably not that far apart. Here’s how I was looking at it: In the first order of things, earnings are credited to the retained earnings account when income statement items are reconciled to balance sheet statements at the end of an accounting period. That’s before payment of any cash dividends, which other things equal are also a deduction to retained earnings account. So, for a given income statement period, the net income flow into retained earnings account is earnings not paid as dividends. During that period, earnings also generally result in balance sheet cash at the first stage, or at least as the default balance sheet result if nothing else is done with the earnings. I.e. cash is generally the initial balance sheet (stock) asset that connects across accounting statements with the flow of income into retained earnings account. At that point, if there is no further change, the flow into retained earnings (or the flow of earnings not paid as dividends) is considered a source of funds and cash is considered a use of funds, as per a sources and uses of funds statement covering that accounting period. I.e. the flow of income not distributed as dividends is also a flow of funds in the form of a change in the stock of retained earnings. Now suppose instead that within the same accounting period the same cash is used to purchase investment goods. By the end of the accounting period, investment goods will now show up as a use of funds (instead of the original cash) and the income flow into retained earnings will show up as a source of funds for the same accounting period. Net result is that by the end of the accounting period you have investment as a stock and retained earnings as… Read more »
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Joseph Laliberté
4 years 6 months ago

JKH:
I see what you are saying. So far so good. I need another clarification though, you said:
“Corporations can fund investment from saving (retained earnings), which is not credit expanding, although it does result in a corporate sector net financial liability as part of the horizontal nexus, offset by a household sector net financial asset (claim on book value of the stock). ”

I can see why it would result in a corporate sector net financial liability, which would be offset by the household sector net financial asset (I guess you are implicitly referring here to wage “leakage” from the corporate sector to the household sector as a result of the investment). I do not see how the resulting net financial assets from the financial sector would be “claim on book value of the stock” though. Could you explain? Thanks

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JKH
4 years 6 months ago

Retained earnings increase the book value of common shares. Shareholders have a claim on that value in liquidation, adjusting for residual effects of liquidation transactions. That value is also reflected on a more viable basis in the marked to market value of the stock, as valued by the stock market. The relationship between book value and market value is obviously not 1:1, but the impact of retained earnings on book value will definitely be incorporated in the market’s valuation of the stock, and therefore in the value of household NFA. The market knows that the firm has retained some of its earnings, it knows what the book value is, and it uses that information in valuing the stock (along with a lot of other things, of course, including what the company’s strategy is for using the money from earnings that it has retained.)

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FDO15
4 years 6 months ago

Retained earnings is profit not paid out in dividend form and reinvested in the company.

Guest
JKH
4 years 6 months ago

The Harless story is quite consistent with the MMR story.

First, he gets the definition of saving right:

“Like “to rest” or “to fast,” the verb “to save” is defined not by what you do but by what you don’t do. “To save” means “to receive income and not to spend it.” … the act of saving is itself entirely passive… Savings are defined as unconsumed income. Thus “savings equal income minus consumption.” You do the algebra.”

That’s the standard definition of saving (he messed up by using the plural, but that’s minor). Harless is smart enough to know you can’t change that definition without committing suicide by inconsistency.

Second, he deliberately doesn’t deal with sector imbalances at all:

“In the simplest case, where there are no inventories, depreciation, government, or foreign trade, it is trivial to prove that “savings equal investment.””

The fact that he doesn’t deal with sector imbalances means he doesn’t touch on the issue of a sectoral mismatch between S and I. If he did, he would.

He uses S = I because he’s doing a single sector economy, not because he’s changing the definition of saving.

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JKH
4 years 6 months ago

BTW, the reason saving must be defined the way that it is – as an income residual – is that we have a monetary economy. And in a monetary economy we must allow for mismatches between saving and investment by sector. We must allow for financial intermediation between business and household sectors, between those sectors (or their private sector combination) and the government sector, and between all of those sectors and the foreign sector.

Conversely, if you define investment as being funded by “spending” from income rather than being funded by saving from income, then it is impossible for there ever to be any such thing as global saving once you’ve added up the sectors. There is only saving and dissaving between sectors. Nobody can save unless it’s at the expense of somebody else dissaving. That seems like nonsense as a concept of global saving. But that’s exactly what’s suggested by sector financial balances if you interpret that equation as an equation of saving – instead of financial saving, which is how Krugman correctly refers to it in the case of the private sector.

Guest
4 years 6 months ago

I though of a metaphor that sort of illuminates this:

Think of a water park, with huge quantities of water being pumped up and run down.

If you look at that park as a black-box “sector,” with the other sector being the water company, all you see is evaporation and a small amount of flow from the water company to the water park.

It’s as if all the Fun-generating water pumping inside the park wasn’t even happening.

The metaphor doesn’t match nearly perfectly (Fun is consumed instantly, so it’s not Investment, and etc.), but it puts across the idea that zooming in and out on different sectors, and consolidating them in different ways, reveals and obscures different dynamics.

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Dan M.
4 years 5 months ago

I like that.

Though for some reason I simply look at it as the economy consisting of two pieces, a real piece (real wealth creation), and the monetary piece (contracts that facilitate the real wealth production). The monetary piece all nets out because it’s not assets in and of themselves, but simply contracts that facilitate the real asset creation, so if all you pay attention to are the contracts that net to zero (especially if you simply net them and don’t look at gross figures), it’s like looking at the cover of a script to decide how good a movie will be after production.

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MMRist
4 years 6 months ago

New here. Can someone explain this to me like I am a 6 year old. Why is the MMT approach wrong? What is so enlightening about this equation?Thanks.

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PeterP
4 years 6 months ago
MMT approach isn’t wrong. The whole ruckus is because MMR tries reeeeeally hard to find a “flaw” in MMT, that is all. MMT says that we should look at and care about accumulation of wealth as the causal factor (this is S-I, not S), and also care about the investment I. The confusion is due to idiotic definition of “saving” “S” in economics. While it is the official definition, calling S “saving” is a misnomer, it is the accounting record of investment, nothing else. S can exist with zero accumulation of both financial and real assets, so it is nowhere near what normal people call “saving”. I found this very enlightening: http://blog.andyharless.com/2009/11/investment-makes-saving-possible.html If the economy consists of people selling and reselling investment assets, it will have plenty of S=I, yet no financial assets will be accumulated and the quantity and value of investment real assets will be constant too, accumulation is zero. So to get excited about S>0 is just unwise. To “save” (colloquially understood) is to spend less than income, or accumulate dollars (closed economy for simplicity): Net Saving (colloq. = accumulation) of the private sector = (income of the private sector) – (spending of the private sector) – taxes = Y-(C+I)-T=C+I+G-C-I- T=G-T this by accounting is equal to S-I. Net saving (accumulation)= G-T = S-I So the accumulation of dollars, which is the colloquial understanding of “saving” is S-I, not S. MMT calls this S-I “Net Saving” and claims this is the important factor, not S itself. In other words, instead of constructing the accumulation (net savings) from S and I, we could use Net Savings and investment “I” as the primary objects and then define S (if we cared, which we shouldn’t): S = Net Savings + I. Why would anybody assign any particular importance to this… Read more »
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AK
4 years 5 months ago

PeterP – my thoughts exactly.

I have refrained from commenting specifically on the “S = I + (S-I)” revelation thus far, because I could not for the life of me figure out what new point – or even, what new clarification – was being made. (NB: That is no disrespect to JKH – his exposition is an eloquent and correct one – I just don’t feel it adds all that much).

The equation S = I + (S – I) simply says that we can place our money in private sector investments, (carrying some level of risk), or “net savings” instruments (which are provided by government and carry no risk).

Risky private investments (I) usually drive innovation and increased standards of living.
Risk-free “net savings” (S-I) provide risk-free certainty of future claims on resources.

Given that the private sector is an amalgamation of individuals with different risk appetites, we can surmise that both risky investments and risk-free “net savings” are desired by the private sector in differing ratios at different times.

I would be delighted if someone could point out to me (i) why I should be too excited about this observation and (ii) where MMT has ignored/obfuscated this.

Guest
4 years 5 months ago

“The equation S = I + (S – I) simply says that we can place our money in private sector investments, (carrying some level of risk), or “net savings” instruments (which are provided by government and carry no risk).”

The household sector can have a positive “S-I” but it is allocated across a range of assets such as equities and cannot be said to be “risk-free”. Even government bonds have an interest rate risk attached to them.

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AK
4 years 5 months ago

No default risk, which is the where the hazy difference between “savings” and “investment” lies, in the layman’s sense.

In any case, the point remains unchanged: government “savings” instruments simply broaden the risk spectrum available to savers.

Guest
4 years 5 months ago

Point being households hold assets which are not just government bonds but other things such as corporate bonds, domestic equities as well – all directly and indirectly. These are not risk free.

Guest
AK
4 years 5 months ago

Of course they do, I said precisely that in all of my posts.

Still failing to see what the revelation is. If MMR simply wants to say that S = I + (S-I) adds “clarity” to the concept private sector savings, then that’s fine; however MMR may want to recognise that this point has already been made in MMT literature many times over.

More importantly – MMT recognises the outright importance of investment (I) as opposed to corporate welfare (long term government debt), and hence is precisely one of the reasons why MMTers argue that government debt should be restricted to the short term.

Guest
4 years 5 months ago

AK,

“Still failing to see what the revelation is.”

An entirely different matter altogether.

You said:

“The equation S = I + (S – I) simply says that we can place our money in private sector investments, (carrying some level of risk), or “net savings” instruments (which are provided by government and carry no risk).

Risky private investments (I) usually drive innovation and increased standards of living.
Risk-free “net savings” (S-I) provide risk-free certainty of future claims on resources.”

which of course is what I took issue with.

Guest
AK
4 years 5 months ago

Ok, so I think your issue is with simply with my use of the word “risk-free”.

I realise that “risk-free” is not an ideal term to describe anything, since even government bonds have interest rate risk attached. But the term “risk free rate” is pretty entrenched in finance language and most people get what it means when used in that context.

Guest
4 years 5 months ago

Ok but “S-I” doesn’t map to risk-free in any sense.

Guest
AK
4 years 5 months ago

I sympathise. But rudeness is a condition of all anonymous internet debate, unfortunately, rather than MMT specifically. I’d say MMT and all related debates are pretty good overall (by internet standards, that is!).

In any case – I look forward to the interesting debates!

Guest
AK
4 years 5 months ago

You seem to be particularly upset about some online bloggers displaying a lack of manners and respect. Certainly a valid reason to be upset. But not a valid reason to imply (as you clearly have in your above series of points) that all/most MMTers are not open to critical debate.

MMR is a criticism of some parts of MMT. It says so on pragcap. And that is absolutely fine – everyone is entitled to criticise. But MMTers are also entitled to respond. In responding I have simply pointed out, as respectfully as possible, that I don’t feel MMR has provided anything new via its “points of difference” between it and MMT. MMR may feel that MMT could use words in a different, better way. But the umbrella terms used in ANY theory, MMT included, are unavoidably going to be subjective and open to misinterpretation. The best way to understand the objective meaning behind MMT’s subjective words is to read the MMT literature to put it in context. I feel that is a more successful way of being accurate, rather than defining and redefining vague words such as “monopoly” and “savings”.

That is ultimately the same reason why I consider S=I+(S-I) as being rather un-illuminating. I have considered, responded, debated and ultimately rejected, as have many other MMTers. Some have rejected respectfully. Some have not. But rejection per se does not equal disrespect.

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JKH
4 years 6 months ago

So as noted further below, if you propose to change the definition of saving such that expenditure on global investment counts as “spending” and does not correspond to global saving, then global saving must identically be equal to zero.

At the same time, there is in excess of $ 100 trillion in financial assets on the books of household balance sheets globally.

So the implication according to your desired definition of saving is that this $ 100 trillion of household financial assets, net of liabilities, is a reasonable measure of (cumulative) household saving (marked to market).

At the same time, cumulative global saving must be zero according to your revised definition.

Are you really comfortable holding those two beliefs simultaneously?

Guest
AK
4 years 5 months ago

Whenever we try to reconcile “layman’s” definitions of the word savings with economic definitions, we inevitably run into issues. The layman tends to define “savings” as any instrument that carries subjectively-defined ‘low’ risk (and can therefore be regarded as a relatively certain guarantee of a claim over future resources); and the layman does not care whether that is a private sector low-risk instrument or a risk-free government instrument.

So to answer your question; yes, it is perfectly possible to hold both beliefs simultaneously, depending on what you choose to define as a ‘reasonable measure of household savings’. If I choose to define only risk-free instruments as “savings” then only government liabilities (S-I) will count. If I choose to broaden the definition, then I can begin to count private-sector instruments too such that (S-I) + arbitrary_%*S is my definition of savings.

So once again, MMR is back to arguing semantics and subjective definitions as a ‘point of difference’ between it and MMT. Clarification is all very well and good, but I do feel we will end up chasing our tails if we continue to argue about the best way to define a subjective word.

Guest
4 years 6 months ago

I pointed this out right here:

“It’s worth keeping in mind that it is just as true to say that the entire world itself cannot “net-save financial assets” anymore than the private sector can. Everyone’s financial asset is someone else’s liability. Viewed on a planetary scale, net financial savings is completely impossible. Unless, you know, we start trading with Newt Gingrich’s moon colony.”

http://www.cnbc.com/id/46573742

Guest
Dan M.
4 years 6 months ago

His point on whether the gov’t should bend to the whim of what people want (the ability to net-save) goes both ways.

During investment booms, when people could care less about treasury instruments, I wonder if the gov’t should still keep a buffer stock out there in spite of the private sector’s lack of apparent demand for that instrument.

Guest
JKH
4 years 6 months ago

Good point.

It’s always wise to check out the view from 40,000 feet, or a quarter of a million miles, as it were.

Guest
Dan M.
4 years 6 months ago

Shouldn’t the gap have gotten wider in 2010 and 2011 with fiscal deficits far in excess of the trade deficit?

Guest
4 years 6 months ago

Makes sense:

http://research.stlouisfed.org/fred2/data/GPSAVE.txt
http://research.stlouisfed.org/fred2/data/GPDI.txt

If you see the graph, the last data point is missing for Q4. So use Q3

Government deficit is not there in the data but from Fed Z.1, Govt deficit ~ 1470bn, CAB minus 447bn

So the sum is $1025bn which is close to $950bn for Q3 and won’t match due to discrepancies which will be corrected later to a lesser discrepancy.

Is that what you were asking?

Guest
Dan M.
4 years 6 months ago

Ramanan,

Not really… basically, we’ve been running $1 Trillion + Fiscal deficits every year since 2009, and our trade deficit has hovered between $300 & 550 billion every year.

If (S-I) is truly a factor of trade surplus/deficit and fiscal surplus/deficit, then the gap between the blue line and the red line should have expanded by $500 Billion or more in 2010 and 2011.

Is there a delayed effect between some of this stuff? It doesn’t seem to match my figures for the size of fiscal & trade deficits during the past decade.

Guest
4 years 6 months ago

Dan M,

Seems consistent with numbers here (Table F.8) http://www.federalreserve.gov/releases/z1/current/z1.pdf#page=22

Guest
Dan M.
4 years 6 months ago

Ramanan,

I don’t know both what specific years you’re trying to measure, or what amounts you are specifically saying they are “consistent with.” Do you mind being a bit more specific?

http://www.davemanuel.com/history-of-deficits-and-surpluses-in-the-united-states.php
http://www.census.gov/foreign-trade/statistics/historical/gands.txt

If you follow those two links, you’ll find that in 2010, we had a $1.3 trillion fiscal deficit, and a $500 Billion trade deficit. That SHOULD mean that the GAP between the blue and red line would GROW by $800 Billion. It did no such thing. It stayed about even. Could someone please explain to me where I’m going wrong?

Guest
4 years 6 months ago

Dan M,

The gap is the difference. It doesn’t grow by that number $800bn

Guest
Dan M.
4 years 6 months ago

I was thinking the graph was in terms of accumulation (a balance, not a flow). Therefore the gap (to me) should have grown over that period.

Thanks for clarifying!

Admin
4 years 6 months ago

The trade deficit was $700B in 2007, its actually been smaller since then (last year it came in at just under $600B).

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