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Monthly Archives: March 2012

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.

What are automatic stabilizers?

An automatic stabilizer is a non-discretionary item in a government budget which kicks in automatically when economic activity decreases.

Unemployment benefits are an example of automatic stabilizers. As economic activity decreases & workers are laid off, the automatic stabilizers kick in to provide a floor of support.

This is a critical concept when talking about Government deficits, because it means that the deficits themselves are outside of the direct control of the budget process. We could say the deficit result is endogenously determined, that is, it is determined by events in the private sector of the economy.

Targeting a desired deficit outcome (such as a balanced budget) becomes impossible because if private sector activity decreases, as people are laid off the automatic stabilizers will kick in and throw the desired deficit result off track.

What are stocks and flows?

When economists talk about stocks and flows of money, they are essentially adding time to the equation.

A flow is a quantity of money measured over a given time period. For example, the Government deficit is a flow, typically measured over a quarter or a year.

The Government debt is a stock, which is the cumulative total of Government deficits. In this way, the deficits accumulate to become the debt. So we say flows accumulate to stocks.

One common measure we frequently see is the Debt to GDP ratio. In my opinion, this is a difficult ratio to draw meaningful conclusions from because it compares a stock to a flow. Presumably a high debt to gdp ratio is bad because it means you are getting less productivity out of each dollar of debt. However, it could also mean that the population has a high amount of savings relative to economic activity. Not necessarily a bad thing.

What is the Monetary Base?

The Monetary Base (also known as high-powered money, or M0) is made up of coins, currency, and bank reserves. The Monetary Base is considered the most liquid form of money for final payment in bank transactions.

In a Nation-state that has Monetary Sovereignty, the Central Bank is the monopoly issuer of the monetary base, although in the US, the Treasury is the issuer of coins and the Central Bank issues the Physical Notes and bank reserves.

As we learned in our post, What are bank reserves?, bank reserves are an IOU of the Central Bank to the commercial banking system. Bank Reserves do not circulate among the public, they are simply an electric entry in the Central Bank’s accounts which can be swapped for physical currency.

The currency in the monetary base consists of both currency is circulation and in bank vaults.

In other posts, we will learn about other measures of money, typically measured by levels of M, such as M1, M2, etc.