Income = Expenditure, and debt

Nothing new here. Just another kick at the debt can. And basic national income accounting.

Income = expenditure is almost always false at the level of the individual. How can it be true for a whole economy, which is just a collection of individuals?

Income = expenditure [in any given year, or month] is rarely true for an individual. Some people spend less than their income, and accumulate savings; while others spend more than their income, and accumulate debt. But you can also get an intuitive sense that it might be a bit different for the economy as a whole; one person's spending is another person's income. The $2,000 I paid the contractor to fix my windows is expenditure for me but income for the contractor (and his suppliers).

"My income = my expenditure" is generally false. But "my income from selling to you stuff that I have produced  = your expenditure on buying from me stuff that I have produced" makes a lot more sense. If I sell $100 of stuff to you, then you must buy $100 of stuff from me. It's just two ways of describing the same thing. Add up all the "my's", and add up all the "you's", and make sure we don't leave anyone out who either buys from us or sells to us, and our income = our expenditure in a closed economy. (In an open economy we must remember to add net exports to expenditure -- the difference between what they buy from us minus what we buy from them).

It works for that $2,000 I paid for the windows, but doesn't work for the $5,000 I paid for a used car (private deal). It's $5,000 expenditure for me, but it's not $5,000 income for the woman who sold me the car. She just swapped a car for $5,000; she didn't earn $5,000 income from the deal. But then, if you wanted to be ornery, you could also say that the contractor who fixed my windows just swapped some of his leisure time for $2,000. Why count the leisure-seller's  $2,000 as income, but not the car-seller's $5,000?

I know that we only count expenditure on newly-produced goods and services as expenditure, but why do we do that?

To take another example, I make a $1,000 capital gain if the value of my assets increases by $1,000, and we normally treat that capital gain as part of my income (at least the taxman does, sooner or later). But that income doesn't seem to be matched by $1,000 of expenditure by anyone else. And we exclude income from capital gains in the income =  expenditure definition of income.

I know that we only count income earned from the production of goods and services, but why do we do that?

Even weirder, what about goods that get produced but don't get sold, and get stuck in inventory? "No problem" says the National Income Accountant, "you really did sell them: you sold them to yourself!". Inventory accumulation is included as both income and (investment) expenditure. Why?

And the distinction between desired and undesired inventory accumulation is always brought out to explain why desired expenditure may be different from actual expenditure, why actual savings always equals actual investment, but desired savings may not equal desired investment, except in equilibrium. But what about a pure service economy, where goods cannot be stored in inventory? Would the Treasury View (government deficit spending must crowd out private spending dollar-for-dollar because investment plus government borrowing must equal private saving in a closed economy) be true in a pure service economy?

Let's start from the beginning.

Suppose (don't ask why) we were really interested in the market for apples. We want to understand why it fluctuates over time. Nothing else really matters. We would find it useful to distinguish 4 different concepts to discuss what is happening: the quantity of apples produced; the quantity of apples supplied (that people want to sell); the quantity of apples demanded (that people want to buy); and the quantity of apples traded.

The quantity of apples actually sold must always equal the quantity actually bought, by definition (and calling it "quantity traded" is just a neutral way of describing the very same thing). But only in equilibrium will quantity supplied = quantity traded = quantity demanded. And quantity produced = quantity traded only if the producers' inventories are neither rising nor falling. But whether or not apples can be stored has no relevance for the conceptual distinction between quantity supplied, quantity traded, and quantity demanded. Those 3 concepts would be just as distinct if we were talking about haircuts instead of apples.

If macroeconomists were fixated on the production of apples, they might define "income" as income from newly-produced apples, and distinguish between actual expenditure on apples (quantity traded) and desired expenditure on apples (quantity demanded). But they are equally fixated on the production of bananas, and haircuts, and all the other goods and services that get produced. So they add them all up. And you can argue about how you ought to add up apples and oranges, but it doesn't matter for income = expenditure. If apples sold = apples bought, and oranges sold = oranges bought, then apples + oranges sold = apples + oranges bought, provided you use the same method of addition on both sides of the equation.

For an individual, your debt rises if your income was less than your expenditure. It can't work the same way for a whole (closed) economy, because income = expenditure. But even if income = expenditure in aggregate, there can be some individuals spending more than their income, and some spending less. The former will be increasing their debt (or reducing their credit). The latter will be increasing their credit (or reducing their debt).

Since Canada has negligible net foreign debt, it cannot be true that Canada is a nation of debtors. Or rather it's a half-truth. Canada is a nation of creditors is the other side of the coin (or balance sheet).

Of course, I could have gotten exactly the same result, and more simply, by ignoring the whole income = expenditure business. Forget about apples sold = apples bought, plus bananas sold = bananas bought. Just look at the market for debt, or IOU's. When I borrow I get money, and give an IOU in return. I sold an IOU. IOU's sold = IOU's bought.

Comments

[Too Much Fed]

test

[Too Much Fed]

"But you can also get an intuitive sense that it might be a bit different for the economy as a whole; one person's spending is another person's income."

No, I don't believe it is. When debt is involved, there is a time mismatch (probably not the correct economic term). One person spends now and pays off the debt over time. Also, what happens when the person defaults?

I believe that we agree that if there is no savings and no debt, income equals spending.

[Too Much Fed]

"It can't work the same way for a whole (closed) economy, because income = expenditure."

I don't believe that is correct, but it could depend on definitions. In that closed economy, define income and define spending.

I hope you had me in mind with this post.

[Too Much Fed]

More comments about this:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/07/why-the-bank-of-canada-should-rise-interest-rates.html

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/07/fiscal-multipliers-in-new-keynesian-models.html

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/07/fiscal-multipliers-in-new-keynesian-models.html

[Too Much Fed]

From:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/07/fiscal-multipliers-in-new-keynesian-models.html

"There's a basic accounting identity that says:

(private Investment-private savings)+(Government spending-Taxes)+(exports-imports)= zero

(I-S)+(G-T)+(X-M)=0

Which we can think of as:

Net private borrowing + net government borrowing + net foreign borrowing (from us) = 0"

(Government spending-Taxes) = net government borrowing ; OK

(exports-imports) = net foreign borrowing ;
I think that is correct

(private Investment-private savings) = Net private borrowing ;

Can you expand on that one? How does spending figure into that?

[Too Much Fed]

From:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/07/greenspan-and-his-critics-again.html

My post:

"and income expands to match the higher capacity to produce income."

Could you expand on that? At first glance that does not seem correct to me.

[Too Much Fed]

From:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/07/greenspan-and-his-critics-again.html

Nick's post:

"Too much Fed: Yes, absolutely. This is the key point behind many of our disagreements.

Let me give an example:

Assume one individual, working half-time and producing and selling $50,000 of goods per year. He wants to work full-time, and has the capacity to produce $100,000 of goods per year, but he only works half-time because he can only find buyers for $50,000. (He is 50% involuntarily unemployed). Assume he initially has no debt, and is spending $50,000 per year on consumption, so is neither saving nor dissaving.

Suppose our individual now decides to spend $60,000 on consumption each year. His income stays at $50,000, he dissaves $10,000, and goes steadily deeper into debt, and as the interest payments mount, his income net of interest gets steadily lower.

Suppose instead our individual now decides to spend $40,000 on consumption each year. His income stays at $50,000, he saves $10,000 per year, and accumulates assets, earns interest, and his income inclusive of interest slowly grows over time.

Now assume a closed economy with one million identical individuals, just like the one above.

Suppose every individual now decides to spend $60,000 on consumption. Each individual now finds that demand for his goods has increased, and he can sell $60,000 of goods each year. So he works more, and increases production and sales to $60,000. Which means his income from producing and selling goods is also now $60,000 also. So he is not dissaving, and not going into debt.

Suppose instead every individual now decides to spend $40,000 on consumption. Each individual now finds that demand for his goods has decreased, and he can only sell $40,000 of goods each year. So he works less, and decreases production and sales to $40,000. Which means his income from producing and selling goods is also now $40,000 also. So he is not saving, and not accumulating assets.

This is the "Paradox of Thrift". In certain special abnormal circumstances (unemployed resources and a demand-constrained economy) what is folly for the individual (consume beyond your income) becomes wise for the aggregate, and what is prudential for the individual (consume less than your income) becomes folly for the aggregate."

[Too Much Fed]

From:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/07/greenspan-and-his-critics-again.html

My 2 posts:

"OK.

"Assume one individual, working half-time and producing and selling $50,000 of goods per year. He wants to work full-time, and has the capacity to produce $100,000 of goods per year, but he only works half-time because he can only find buyers for $50,000."

Can you add a corporation to that? The corporation wants to pay workers the same or less, maximize margins, increase quantities, and increase prices all to maximize corporate profits."

And ...

""Now assume a closed economy with one million identical individuals, just like the one above."

Can you add a private fed to that? It controls the "fungible" money supply and its composition (assume it has considerable influence over the amount of gov't debt).

At some point I might want two groups, 10,000 in one (1%) and 990,000 (99%) in another."

[Too Much Fed]

Sorry for all the posts, but I'm hoping they are all relevant.

[Nick Rowe]

Too much Fed: (from first comment here) "No, I don't believe it is. When debt is involved, there is a time mismatch (probably not the correct economic term). One person spends now and pays off the debt over time. Also, what happens when the person defaults?"

OK. I think I now see where you are coming from with the 'time mismatch'.

Yes, over an individual's whole lifetime, his income will equal his expenditure (providing he does not default on his debt, or make or receive gifts, etc.). But income = expenditure will not (usually) be true for the individual in any particular year.

But in aggregate, income = expenditure is true each and every year, month, day.

[Declan]

I think it's clear enough that if money is owed by somebody, it is also owed to somebody, the interesting question is what are the impacts of changes in the aggregate amount owed relative to general economic activity?

[Nick Rowe]

Declan: A first order approximation is that an increase in gross debt, with no change in net debt, doesn't have any aggregate effects. Suppose we randomly say that every odd-numbered person owes $1,000 to every even-numbered person. The odds are poorer, and consume less; the evens are richer, and consume more. In aggregate it cancels.

But you can think of many secondary effects. Risk of bankruptcy and default is bigger, etc. All have to do with non-linearities, I think.

[Declan]

Off the top of my head, I see a few possible 'secondary' impacts:

1) Changes in the money supply are primarily driven by the creation of new debt (and destruction of existing debt)
2) Debt introduces a nominal element to an otherwise real system (i.e. with no debt we could double all prices and it would make no difference. With household debt at 130% of GDP, doubling all prices would result in a wealth transfer of roughly 65% of GDP from household creditors to debtor households)
3) The sensitivity of the economy to interest rate changes is proportional to the debt level (why is Japan's interest rate always at 0? Because their debt is so high that any higher rate would destroy their economy - same is true for the U.S. now - recent history suggests Canada hasn't quite reached this level yet) making monetary policy much more delicate
4 a) Similarly, the sensitivity of the economy to the velocity of money rises as debt levels rise - the money needs to circulate quickly if the massive interest payments are to be made
4 b) Individual default risks rise along with debt levels while the systemic risk from interconnected debts rises much faster

[Nick Rowe]

Declan: I think of these as 'secondary' impacts (not the bast word, but I can't think of a better) because they are the difference between two 'primary impacts'. The increased assets of the creditors causes them to move in one direction; and the increased liabilities of the debtors causes them to move in the opposite direction. The aggregate effect is the difference between those two 'primary' effects.

But that's just from the macro (aggregate) perspective.

1,2,4b: agreed

4a: interesting. Let me re-state it: for a given price level, real income, and nominal interest rate, an increase in gross debt will increase the demand for money (because you need to make extra transactions to pay and receive interest). So income velocity will be lower, for a given transactions velocity. Agreed. But I'm not sure how that translates into 'sensitivity'.

3. By 'sensitivity' here I think you mean "change in number of defaults per percentage point change in interest rate"? (Rather than say "change in desired spending per percentage point change in interest rate")?

[Too Much Fed]

"But in aggregate, income = expenditure is true each and every year, month, day."

I am beginning to think we have different definitions of income and expenditure. One difference might be that your income definition includes some kind of velocity and maybe other things while mine does NOT.

[Too Much Fed]

"Declan: A first order approximation is that an increase in gross debt, with no change in net debt, doesn't have any aggregate effects. Suppose we randomly say that every odd-numbered person owes $1,000 to every even-numbered person. The odds are poorer, and consume less; the evens are richer, and consume more. In aggregate it cancels."

Could you go over gross debt vs. net debt? The debt I am talking about does NOT cancel in aggregate.

[Too Much Fed]

"With household debt at 130% of GDP, doubling all prices would result in a wealth transfer of roughly 65% of GDP from household creditors to debtor households)"

I don't necessarily agree with 2). What if prices double and wages stay the same? How does that help households with too much debt?

[Too Much Fed]

Declan said: "1) Changes in the money supply are primarily driven by the creation of new debt (and destruction of existing debt)"

Is the fed doing this on purpose (the "fungible" money supply skewed towards too much debt)?

At this point in time, I agree.

[Too Much Fed]

I think 3) and 4a) need expanded upon.

[Nick Rowe]

My income (according to the National Income accounting definition) = the market value of the goods I produced this year.

Gross vs net debt: Suppose I borrow $1 from you. Gross debt is $1. Net debt (my positive debt of $1 minus your negative debt (credit) of $1) = $0

If prices double, wages stay the same, but real output stays the same, then real income stays the same, and money income (measured in dollars) doubles. What happens is that the distribution of income changes, away from wage income towards non-wage income. Wages are not the same as income. Capitalists are people too!

[Too Much Fed]

"My income (according to the National Income accounting definition) = the market value of the goods I produced this year."

BINGO! There is the problem!!! IMO, "income" in a closed economy should be defined as the part of the "fungible" money supply that has no debt repayment terms attached. That would be currency in circulation (CURRCIR).

When someone goes to purchase a car or house, are "my income (currency)" and debt fungible?

How do you get from CURRCIR to your definition (which is more like GDP)? Velocity? Other?

[Too Much Fed]

"If prices double, wages stay the same, but real output stays the same,"

Huh? How does that happen? More debt on the wage earners? Force an economy to become a net exporter ("pulling an IMF")?

I am going to assume not the asset holders spending more because most of them are excess savers already.

What if real output stays the same, but real final sales fall because of that negative real earnings growth?

[Too Much Fed]

"What happens is that the distribution of income changes, away from wage income towards non-wage income."

Does towards non-wage income mean corporate profits and interest payments?

Has this been happening since about 1981 when volcker (yuck!) raised interest rates and IMO the fed started targeting wages so they could increase gross debt levels and increase wealth/income inequality?

[Too Much Fed]

"Capitalists are people too!"

For most capitalists, I seriously question that.

[Too Much Fed]

My post: "With household debt at 130% of GDP, doubling all prices would result in a wealth transfer of roughly 65% of GDP from household creditors to debtor households)"

I don't necessarily agree with 2). What if prices double and wages stay the same? How does that help households with too much debt?"

Nick post: "What happens is that the distribution of income changes, away from wage income towards non-wage income. Wages are not the same as income."

If most households with too much debt are wage earners, how does negative real earnings growth allow them to pay the debt? Doesn't it make them more likely to default? Is that what the debt holders are hoping for so they can seize the collateral or refinance the collateral if it is rising in value UNTIL the collateral starts to fall in value?

[Bill Woolsey]

Too much Fed:

Coming up with your own odd definitions of income is going to cause you trouble.

Perhaps currency in circulation is especially important for some reason or other, but it isn't close to what anyone thinks of as income.

How much currency do you have? How much do you earn per year from your job and investments?

[Nick Rowe]

Currency is a stock ($). Income is a flow ($ per unit of time). Currency can't be income, because they don't even have the same units.

IIRC, currency in Canada is about $1,000 per person. Is that $1,000 income per year? per month? per week?

Is my income equal to the amount of currency I own? (Some people barely use currency at all). Or is it the amount of currency i get paid? (About $0 in my case, since Carleton refuses to pay me in cash, and insists on direct deposit into my chequing account).

[Too Much Fed]

Nick said: "My income (according to the National Income accounting definition) = the market value of the goods I produced this year."

What is your definition of "my income" for an individual?

To me produced implies supply. Is that correct?

And said: "Wages are not the same as income."

I think here is another definition problem. If you say income to almost all people (and a lot of economists too), they will think wage income.

[Too Much Fed]

Nick said: "Currency is a stock ($). Income is a flow ($ per unit of time). Currency can't be income, because they don't even have the same units."

Does velocity of the currency have units of (per unit of time)?

[Patrick]

I think (and no doubt I'll be corrected if I'm wrong) velocity of money is a frequency so it must be 1/t. Though if the time period is given or known it would just be a number.

[Nick Rowe]

Yes, Patrick is right. Velocity has the dimensions 1/time, so MV has the dimensions $/time, and so has the same dimensions as (nominal) income.

"produced" doesn't always imply "supply", but they are normally close, and I don't think it matters for this argument. We produce goods and services with the intention of selling (supplying) them. We can get into definitional questions about producing goods for your own use, but leave them aside. The bigger difference between "produce" and "supply" is when we want to produce and sell more goods than we actually produce, but we don't produce them because we know nobody wants to buy them. In this case, quantity produced = quantity demanded (the quantity people want to buy), but is less than quantity supplied (the quantity we would like to sell, if we could find buyers).

The definition of "my income" for an individual is exactly what I said above: my income is the market value of the goods I produce. At least, that's the National income accounting definition. Yes, it is very close to GDP (I'm ignoring a couple of technical differences to do with capital depreciation and goods produced by foreigners on Canadian soil).

[Nick Rowe]

" If you say income to almost all people (and a lot of economists too), they will think wage income."

Agreed. They do, and shouldn't. They are forgetting, for example, the incomes of retired people, that derive mostly from the interest earned on their prior savings.

The simplest way to think of it is that goods are produced by labour, land, and capital equipment. About 2/3 of total income comes from labour (wages and salaries), but the rest from land and capital.

[Too Much Fed]

This sounds like a debate on what the definition of inflation is. So... I will TRY to put a descriptor of income in my posts.

Examples are price inflation and wage income.

Would everyone else being willing to do the same?

[Too Much Fed]

I still think income is a misnomer because when I think about wage income, corporate profit income, rent income, and interest income there is no debt repayment involved.

It seems to me that debt has affected both national income and national expenditure.

[Too Much Fed]

"To take another example, I make a $1,000 capital gain if the value of my assets increases by $1,000, and we normally treat that capital gain as part of my income (at least the taxman does, sooner or later). But that income doesn't seem to be matched by $1,000 of expenditure by anyone else. And we exclude income from capital gains in the income = expenditure definition of income.

I know that we only count income earned from the production of goods and services, but why do we do that?"

IMO, your model is not picking up on changes in people's standard of living and changes in people's retirement date.

[Nick Rowe]

Too much Fed:
"I still think income is a misnomer because when I think about wage income, corporate profit income, rent income, and interest income there is no debt repayment involved.

It seems to me that debt has affected both national income and national expenditure."

I think this discussion is going somewhere.

Let's consider this simple example:

Two people, A and B, in a closed economy. Start out with no debt. A and B each earn $1,000 per year from producing and selling $1,000 worth of goods to each other. National income = $2,000. National expenditure = $2,000

Now suppose that A borrows $1,000 from B, and pays 10% interest, so A pays B $100 per year interest (it's an interest only loan, to keep things simple). No additional borrowing or increase in debt thereafter.

What is :A's income and expenditure; B's income and expenditure; national income and expenditure?

According to national income accounting, the answers stay exactly the same as before. The $100 interest is treated as a transfer payment, and is not included in national income, since it is not income from producing goods. Expenditure also stays the same, because that $100 is not expenditure on goods.

But you can see how it looks different at the level of the individual.

Does this example capture the root of our disagreements?

[Too Much Fed]

Nick said: "I think this discussion is going somewhere."

Yes.Yes.Yes!

Nick said: "But you can see how it looks different at the level of the individual.

Does this example capture the root of our disagreements?"

Finally. Finally. Finally!

In the two person example and under the most extreme condition, could the one person eventually end up with all the currency and assets and the other person ends up with the debt (becomes a permanent rentier)?

[Too Much Fed]

Closed economy with 1,000 people. 1 is the fed, 1 is a bank CEO, 1 bank employee is for consumer debt, 1 bank employee is a trader who borrows short to speculate in financial assets, 1 is an owner of a corporation that produces everything, 5 are on the bank's board, and 990 are employed at the corporation. Throw a "fungible" money supply on the closed economy.

Everyone plans to retire at 65 at a certain standard of living. Productivity shock happens and everyone can retire at 62. The 10 get greedy. Instead of increasing CURRCIR and real wages, they "open" the economy to another economy with cheaper labor. The productivity shock and cheaper labor lead to better margins (either thru fewer employees, fewer hours, or lower wages), but the 10 need to convince the other 990 go into debt to keep quantities and prices slightly positive. If the 990 go into debt to maintain their standard of living in the present, they now will need to work longer.

It is somewhat negative real earnings growth (lower standard of living) and more debt on the 990 and extremely positive real earnings growth and excess savings on the 10. The 990 have to work longer to retire, and the 10 could retire at about any time but won't. Eventually, the 990 may get so far in debt they can never retire. They become permanent debt slaves to the interest payments of the 10.

Notice the "fungible" money supply skews towards too much debt. I think the closed economy's money supply also becomes "more fractional".

Does that make any sense? I typed it in a hurry.

[Nick Rowe]

Too much Fed: I will return. Have just been distracted recently.