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Category Archives: Economics

Financial Assets and Real Assets: What is the difference?

One way to divide the economy is into financial assets and real assets. Making this distinction allows us to make judgments about intangible ideas such as value, productivity and net worth .

Financial assets can be roughly divided into two classifications: 1. currency or deposits and 2. paper assets such as stocks and bonds. Mortgage notes are also financial assets, generally held by banks with a real asset as collateral.

Financial assets generally derive their value from a contractual claim on the liability of another. This is why, if you cancelled out all the financial assets in the world, what you would be left with is all the Real Assets.

Real assets could also be broken down into two categories: tangible assets and intangible assets. Tangible assets are anything which can be physically touched, including real estate and personal property, such as an antique chair or work of art. Intangible assets would be items like copyrights, trademarks or patents, which can be owned and transferred but have no, or minimal, physical substance.

What are the elements of business profits?

This post isn’t about making great hires, having a badass product or service, or making smart cost-control purchases.

This is a look at business profits at the economy wide (or macro) level. It is inspired (damn near copied!) from this post by Bill Mitchell. I’m sure it sounds dreadful, but stick with me through the equation and hopefully it will be rewarding.

The profit equation was developed by economist Michal Kalecki using a simplified accounting model, and then expanded to include additional elements. Let’s jump straight to the expanded conclusion. The equation is: Pn = I + (G – T) + NX + Cp – Sw.

What this says is that Gross Profits after tax (Pn) equals Gross Investment (I) plus Government deficits (g-t), plus the export surplus (Nx) plus Capitalist consumption (Cp) minus household savings (Sw).

Gross Investment (I) is business investment plus household investment, which is mostly new residential real estate.

Investment (I) can generally be thought of as any new bank lending for the given period.

Government deficits are the amount the Government spends over the amount it taxes. So we can see that, contrary to conventional wisdom, deficits add directly to private profits and will allow for increased “capital formation” (code for investment), which is an addition to the real assets in the economy.

An export surplus is the opposite of a trade deficit. It will add foreign currency to the domestic sector as the sale of goods and services abroad outstrip the amount of dollars sent abroad through imports. If there is a trade deficit which sends dollars abroad then that deficit, if it becomes chronic, can create a domestic demand problem as those dollars are not able to be recycled domestically. This is the situation we are currently in in the US and requires one of the other elements (New investment, Government deficits, decreased household savings) to pick up the slack in demand.

Household savings, likewise, act as a drain on demand, and will require additional investment in the next period to maintain business revenues and profits.

Finally, as Bill says in the post linked to above: “when the government runs a surplus it reduces profits via its squeeze on aggregate income. That is why all the business sector should be screaming at the fiscal austerity plans that are rampant at present.”

So now we can see that the two primary drivers of the economy (as well as business profits) are new private investment and government deficits, with the trade surplus being a lesser element. We can also get why we hear such a clamor in the news media for a more export driven policy, so as to maintain the ideological bias against deficits as a critical component of economic health.

Government is the investor of last resort

There’s been a lot of keyboard punches thrown recently over the concepts of Savings and Investment. To sum up, Modern Monetary Realism (MMR) has accused Modern Monetary Theory (MMT) of overlooking the importance of business investment as a driver of global savings. While I might agree with this critique to a point, I think it in turns overlooks an important MMT point which MMR would be well-served to poach.

As a quick background–because I haven’t said much about Savings (S) or Investment (I) on this site yet–the idea is that Investment (no matter what it’s original source, public or private sector) becomes Savings as a “leakage” in demand. As a simple example, when you receive your paycheck from your employer, it is immediately kept in your accounts as “savings,” until you on-spend it at the grocery store as consumption, at which point it becomes savings, or “retained earnings” of the store. Any income you don’t spend over the long term remains your savings.

Now, it is not well understood that both the private business sector and the public Government sector work, essentially, from negative equity positions to act as the source of net worth for the private household sector. This is the point that MMR is making. But likewise, the business sector needs revenues as a source of cash flow to feed their original investment. As investment becomes savings, an increase in new investment is necessary to provide those revenues.

The point that MMT makes is that the Government sector has a special position as the issuer of the Monetary Base (currency and bank reserves) in the economy. They can, essentially, create new investment whenever necessary while their needs for revenue to fund that new investment is, in a very real sense, relaxed. A business which is short of revenue will not make new investment until revenues pick up. A Government has no such restriction, and, in times of a shortage of new business investment, must step in to fill the gap. It’s failure to do so on a sufficient scale results in recession. In this way Government becomes the Investor of last resort.

Practicing “Sound Money” principles doesn’t work

In a previous post, we defined “sound money” as the practice of Governments to balance their budget over the business cycle.

Understanding why sound money principles lead to recession and depression requires an understanding of “sector balances.”

In a nutshell, the budget balances of the Government, domestic private sector and foreign sector will net to zero.  If we assume a balanced trade account (imports=exports) then the government surplus will exactly equal the private sector deficit.  Conversely, a government deficit will exactly equal the private sector surplus  (I had demonstrated this in the post linked to above, so you can go there and see it for yourself).

Once we have this, we can understand that when the Government runs consistent surpluses, the private sector will be in jeopardy.

Let’s say, for example, the Government runs a surplus of $200 billion for 3 straight years, and that the trade balance is neutral (imports=exports).  If this is the case, the private sector will have spent $600 billion more than they earned over the same period.  In order to keep up their spending, the private sector will be forced to either spend down existing savings or increase their borrowings by the same amount.

For reference, the last time the US ran consistent surpluses prior to the late 1990′s was the late 1920′s, just before the Great Depression.

This is why Governments very rarely run surpluses, why they never pay off the National Debt –the one time the US did this, in 1835, a particularly nasty depression resulted–and why attempting to run down deficits during a downturn in private credit creation, such as now, is a recipe for disaster.

 

 

 

What is the gold standard?

The Gold standard is the practice of Governments to fix their currency to the price of Gold, and to offer to exchange their currency for an equivalent amount of it.

For example, if the price of the currency was set at $100 per ounce of gold, then $1 would be worth and exchanged for 1/100th of an oz. of gold.

Other commodities or a basket of commodities could also be used to set the price of the currency.

The United States officially went off the Gold Standard in 1971.

What is sound money?

Sound money is the concept of the Government balancing it’s budget over the business cycle  (Typically represented as one year).

In Austrian economics, sound money is tied to a commodity money regime, such as the gold standard.  When used this way, Government spending is limited by the amount of gold in the world (and held by the Government) which prevents runaway spending and inflation.

In a fiat money regime (absent the gold standard), there is no such limitation. Governments are operationally unconstrained in their spending, so political, social and ideological constraints are placed upon Governments to prevent profligate spending.

Nearly all modern Governments profess a goal toward sound money.  In addition, nearly all economists, conservative and progressive alike, profess sound money principles to be a natural law of economics.

Very few Governments actually achieve it in practice.  The reason for this is simple: a growing economy requires a growing supply of money.  The only other way  for the money supply to grow is for entrepreneurs to spend bank credit.   When sound money principles are put into use, recession, depression and volatile business cycles are the result.

 

What is an ELR (job guarantee) program?

An ELR (employer of last resort) program is a government jobs program to employ labor for which there is no bid in the private market. An ELR program would provide a “buffer stock” of jobs to ready, willing and able labor; typically at some minimum wage.

Proponents of a job guarantee argue five primary points:

1.  The job guarantee would allow unused labor resources in the economy to match up with needed infrastructure improvements such as building bridges, roads and levees.  This would provide greater infrastructure for private sector activity.

2.  The job guarantee would allow for greater price stability in the economy.  As there is effectively “no bid” for the labor, government could spend modestly on a program without causing inflation.  Furthermore, as the economy improved and workers transitioned back to the private sector, the job guarantee program would employ fewer workers and result in less government spending.

3.  The job guarantee would allow for a greater level of economic activity in the economy, increased spending on other goods and services and cushion against downturns; preventing many personal bankruptcies and foreclosures.

4.  The job guarantee would enable the government to spend less on other “welfare” type transfer payments and keep the skills of employed workers sharp, enabling them to more easily transition to private sector employment when growth resumes.  In addition, “need” based crime would be reduced.

Finally, proponents argue, a job guarantee is the only way to to fully close the spending gap (resulting from government taxes and private savings) and eliminate unemployment.

Warren Mosler, a former candidate for Senate in Connecticut, proposes an $8 per hour wage here.

For more information on how a job guarantee could be implemented, see  here and here.

 

 

What is a balance sheet recession?

You won’t hear this phrase uttered by the mainstream media, but a balance sheet recession is economist Richard Koo’s term for an economic condition of private sector over-indebtedness. Koo termed this phrase based on his experiences during the still-ongoing Japanese malaise which began over 20 years ago, resulting in low government bond rates, minimal economic growth and fits of deflation.

The Japanese event was triggered by a Real Estate boom and bust.  It resulted in corporate balance sheets being over-leveraged. As firms paid back debt (destroying money), it resulted in lower incomes and decreased economic activity.

This is the exact scenario we find ourselves in today in the US, although it is households which are experiencing the balance sheet recession, more so than firms. Our financial institutions, the largest of which were propped up by government support in 2008-2009 are also still experiencing a balance sheet crisis.

During the 1990’s and early 2000’s, households increased their debt as confidence in new technology companies and portfolio wealth exploded. Unfortunately, President Clinton then exacerbated the private-debt explosion by running government surpluses in the late 90’s. This meant that, as the US was running an account deficit (importing more than exporting), Private Sector savings necessarily had to turn negative. The tech bubble then popped, only to be propped up by the housing bubble of the early 2000’s.   All of this reinforced the private debt explosion, ultimately reaching heights greater than the Great Depression, which then reversed course in late 2008.

As a result, housing prices have plummeted, incomes have been reduced and households find themselves servicing a greater amount of debt on smaller income. This is a balance sheet recession, and only when private debt levels return to a sustainable level will significant economic growth resume.