Never Reason from an Accounting Identity, Redux

Economic confusion all around

Re-post of a core Economic Forces idea that is worth repeating

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If you ever come across an economic argument that seems to make sense but goes completely against conventional economic wisdom, it’s probably “reasoning from an accounting identity.” Run in the other direction. Accounting does not explain anything. That’s why we have price theory.

Take the following example. We all know that “Growth in real GDP depends on only four factors: consumption, government spending, business investment and net exports (the difference between exports and imports).” That comes from the definition of GDP as GDP = C + I + G + NX, so any growth in GDP comes from growth in one of those factors.

From there, one may mistakenly believe that, as Peter Navarro suggested, “Reducing a trade deficit through tough, smart negotiations is a way to increase net exports — and boost the rate of economic growth.” After all, there’s an equal sign there! Y EQUALS C + I + G + NX. It’s just math losers. QED.

No. Wrong.

Just as we never reason from a price change, we need to never reason from an accounting identity. My income equals my savings plus my consumption: I = S + C. But we would never say that if I spend more money, that will cause my income to rise.

It all depends on what caused the change. In my income example, more spending could cause me to work more to cover those expenses. Or I could save less. It depends. In the GDP example, we need to know what caused the change in net exports (or any other part of the equation). We need to be explicit about what actually caused the change in net exports. Exports don’t simply fall from the sky, and move up and down based on our wishes. We need to know the causes. There is an added complication in this example since the reason we subtract imports from GDP is that they are already part of consumption (C) and shouldn't have been since imports are not domestic production.

Did we discover a new fracking technology? Net exports will likely go up, as will GDP. Did we impose tariffs on imports from China? Those are likely inputs into other production processes and, therefore, lower “US gross domestic production,” aka GDP. Therefore, the tariffs cause an increase in net exports, but they cause a decrease in GDP. The reason is that the first mover— the cause of tariffs— pushed up NX, but it also at the same time pushed down something else, such as the C in C+I+G+NX. To say GDP moves up if net exports move up requires an assumption the C, I, and G are not changing.

For basically any macroeconomic example we are interested in, holding C, I, and G fixed is a ridiculous assumption. We need to think about is all affected by a certain cause. Luckily, as I’ve explained before, economics helps us establish causation.

Economics—whether theoretical or empirical—helps us establish causal claims about the world. If X changes, then Y changes. If you prefer the framing of counterfactuals: If X had been different, then Y would have been different.

Does Density Increase Housing Prices?

Yes, the accounting identity must hold, and we need to keep track of that, but it tells us nothing about causation.

Luckily, price theory allows us to trace out the myriad of effects that are caused by a single policy change. We must constantly ask, and then what? Suppose China (for political reasons) decides it doesn’t want its companies to trade with US companies and stops them from doing so. Now from here, we can try to trace out different implications. Chinese firms stop producing goods for exports. And then what? US consumers have fewer goods to consume (C goes down). And then what? They substitute partially to US manufacturing (C partially goes up). And then what? Workers produce fewer services (C goes down). And so on.

That’s just following the goods being traded. The policy change also means that Chinese firms have less demand for dollars. And then what happens? They weren't using those for purchasing US goods, so they must have invested in US debt or equities. And so on.

Every semester I make sure to include “Never Reason from an Accounting Identity” in my courses. The reason I’m mentioning trade policy today is that there was a recent “handbook for conservative policymakers” released by American Compass. One of their policy proposals was to eliminate the trade deficit. To accomplish this, we should:

Establish a uniform Global Tariff on all imports, set initially at 10% and adjusted automatically each year based on the trade deficit. After any year when the trade deficit has persisted, the tariff would increase by five percentage points for the following year. After any year when trade is in balance or surplus, the tariff would decline by five points the following year.

The essays defending this general position (although not necessarily the exact policy proposal) are just a series of reasoning from accounting. There is no economic content. As one essay put it,

For decades, the implicit and explicit subsidies to manufacturers that have driven surpluses in countries like China and Germany have caused global manufacturing to migrate from deficit countries to surplus countries, and from none more so than the largest deficit country by far, the United States.

The argument above supposes that there exist countries out there in the ether called surplus countries, and manufacturing moves to them. In reality, when you’re not just playing with definitions but looking at causation, Chinese subsidies increase manufacturing which increases the trade surplus (in some cases). The causal arrows point from subsidy to manufacturing and trade surplus, not from surplus to manufacturing.

The essay goes on to say that “American trade deficits force Americans to choose between higher unemployment, more household debt, or greater fiscal deficits.” Ignore the unemployment red-herring. The trade deficit doesn’t force (or cause) household debt or fiscal deficits. Something else causes both trade deficits and fiscal deficits to go up together.

For example, if people really want US treasury debt because there is a global financial crisis and US treasuries are the safest asset available, they will buy up more debt, driving down interest rates, and increasing fiscal deficits. They will want dollars to buy that debt, so they will need to sell goods to get dollars. The unique position of US treasuries in the global financial market causes both fiscal and trade deficits. They don’t cause each other. It’s a bit more complicated since we need economics to trace out causation and can’t just look at an equation, but it is vital.

The purpose of this newsletter is not to trace out all the implications of a trade war. The purpose is to point out that we cannot simply reason from the accounting identity. We need to take seriously all of the feedback.

Profits Do Not Cause Inflation

Before we mock the trade deficit people too much (who, in this case, are “conservatives”), there has been a more prominent example in recent years that has generally come from people on the left. It is the idea that profits cause inflation.

After all, any revenue PQ = Costs + Profits. So P = Costs/Q + Profits/Q. If inflation means that P goes up, it must be “caused” by costs or profits.

No, again. Stop it. This is like saying consumption causes income.

Instead, we need to ask, what changed? What actually caused things to be different? Did the Fed print a bunch of money? Then consumer spending will go up, which will drive up prices, costs, and profits. It may be that profits rose more than costs but that’s not a causal relationship. Or did prices rise because of an oil shock? Costs will probably rise, along with prices, but it could be that profits fall enough to offset that. We can do the decomposition, and that’s fun, but let’s not mistake that for economic analysis.

Instead, we need to use economic reasoning to think through what is causing profits and prices to move, sometimes in the same direction and sometimes in different directions.

Economic ignorance is omnipresent. Price theory is the answer. Economic Forces is the answer.