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This is a fantastic post and I thank you for it. In a just world it would be on the first page of Google results for the query "loanable funds".

Thanks Owen!

Nick, eagerly awaiting the second installment...

Thanks marcus! Will have to clear my head a bit, before tackling the next bits.

Great post, Nick. I've always found it more intuitive to think in terms of demand-for-assets than saving-investment.

"Assets are things too. Like land, houses, machines, shares, bonds, IOUs, etc."

You added etc. at the end of that sentence. If houses are included as assets, can we let things like cars and sofas leak into this category? Antiques? What about things I keep in my refrigerator/pantry, like spices or pickles or honey? They have a longer life than some of the assets I've bought, say like a 3-month Treasury bill.

Lots of good stuff in here. Back to the old "Abolish Saving" post that I've been sharing ever since...

A few different ways of thinking about this that have helped me untangle it:

>so what do you do with your income, if you don't spend it on consumption? You buy/accumulate assets.

"Accumulate" is right! "Buy" confuses people. Once you receive income, you've got the assets. (Probably M assets). You don't need to buy them.

You can swap them for different assets, of course, to change your (and the other swapper's) portfolio composition. (If you're holding non-M assets, this will prob be a two-step process: swap Apple shares for M assets, and M assets for Treasuries. Because sellers almost all insist on receiving fixed-price M assets for purchases. But that's just mechanical.)

And swapping assets is not an choice alternative to buying (and maybe consuming) newly produced goods and services. "Should I rebalance my portfolio tonight, or go out for an opulent dinner?" That's not an apples to Apple decision.

>the asset that gets used as Unit of Account and Medium of Exchange

Can make this clearer, I think:

The unit of account is an (arbitrary) measurement unit that is used to numerate value for heterogenous goods. Can't xfer The Inch to someone, only inches of something.

Most (all?) financial instruments — including land titles — have variable market prices numerated in the UoA. (For ~85% of assets, that price is instantly or fairly easily observable.)

But yes, M instruments (your MofE?) are special: Their price is institutionally hard-pegged to the unit of account. (That's their sine qua non.) So, all that portfolio swapping/churn can have zero effect on either P or Q of M assets.

Pre-GFC, the Q of M assets could only change quite slowly via commercial bank net new lending. The complex mechanics of QE etc has changed that, but still, ignoring those Fed/bank machinations: The market can only effectuate a collective desire for a higher proportion of M assets by everyone selling down (in circles) the price of variable-priced assets.

Voila, less wealth, with a higher % being M assets.

Which means that nominal holding gains/losses — largely ignored in econ theory — are the very mechanism whereby "demand for money" and related concepts have their market effects.

I'll stop there, thanks for listening...

Thanks JP! I would definitely include those things as assets. And when we think of it this way, it seems a bit daft to draw a line between *immediate* consumption vs everything else, which is what the standard accounting does. Does it even make sense to distinguish newly-produced vs used goods? Recessions are declines in trade, not just trade in newly-produced goods.

(The thing I should have been more explicit about though is the "double counting" problem. Like if a firm issues shares to buy land. We can't count both the shares and the land. *But*, those shares are much more liquid than the land, so may be worth more. Which brings up the whole issue of financial intermediation, of course.)

Thanks Steve: My apologies; I just found your comment stuck in the spam filter, and fished it out.

""Accumulate" is right! "Buy" confuses people. Once you receive income, you've got the assets. (Probably M assets). You don't need to buy them. "

Yep! I kept thinking about how to write that little bit. "Buy assets" works for most assets, but doesn't work for money (though we still talk about "demand for money"). And we accumulate assets when we buy them, and I wanted "accumulate" in there, so I wondered about saying "buy and accumulate", but that sounds like 2 separate things. So eventually went for "buy/accumulate".

I like this, Nick. But I always struggle with the demand curve for assets. This Warren Buffett quote always does it for me: “I’m going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the ‘Hallelujah Chorus’ in the Buffett household. When hamburgers go up in price, we weep. For most people, it’s the same with everything in life they will be buying — except stocks. When stocks go down and you can get more for your money, people don’t like them anymore.” This might just be an edge case for assets but still complicates the intuition somewhat!

Thanks Ravi. The thing with assets, unlike hamburgers, is that when people buy assets they are usually planning to sell them again, later. So a price that is higher means the same flow of dividends (or rents/whatever) costs you more, so you want to buy less (like hamburgers). But a price that is *rising more quickly* means you get more when you sell it later, so you want to buy more (unlike hamburgers). It's the distinction between a *high* price and a *rising* price. But people don't always get that distinction, and extrapolate from a price that has risen to a price that will rise in future.

Put "price" on the axis, and the demand curve slopes down. Put "rate of change of the price" on the axis, and the demand curve slopes up.

Blogging is dead - long live blogging!

A quick attempt to untangle this from the 'Accounting View' for those interested (see link in name):

What you call assets needs to be divided into two different types of things.

1) There are things I possess / own (have a title to) which, depending on the right conveyed by the title, have a marketable value for me in the foreseeable future. These assets count towards my savings. The markets for these assets, subject to supply and demand, tell me what my saving is worth (exchange value) in terms of the unit of account. Accountants can determine this value according to different methods (mark to market, e.g.) periodically.

2) Then there is my trading history. I may have given assets or goods such as my thoughts, labour, land, other endowments to someone else which, if I'm not altruistically enclined (say, as stay-home parent), I will want to have recorded in one of the following ways according to my risk preferences: as money (low risk, low return social credit), bonds / IOUs (higher risk social or private credit), equity (high risk private credit) etc...

These records will hopefully allow me to acquire any of the things covered by 1), as well as consumer goods, in future. For each unit recorded on my behalf for a good given, someone else must have one unit subtracted for a good received from their account. Goods sold = goods bought. This equality is what makes balance sheets balance. They measure social relations between (groups of) people.

For me, as an individual, 1) and 2) are more or less interchangeable as they both represent future goods. The mix of 1) and 2) determines my net value (=savings) which might be positive or negative or 0 as well as my risk profile (leverage etc.). Individuals do not have balance sheets.

Money is special in the sense that the counter-party to a credit unit is society as a whole (including myself) which, in turn, makes it low risk / reward (i.e. acceptable to hold at 0 interest) and, for most practical purposes, interchangeable with the UoA.

To the extent that the goods described in 1) are 'funds', they are not loaned. A good received on credit must not be returned for the debt to be extinguished (unless explicitly stated in a contract = special case). Rather, any good of equal value, as measured in the UoA (plus interest), even one not yet existent, can be sold for the debt to be extinguished. The only requirement is that someone else chooses to buy it.

This also means that each and every credit transaction (2) is subject to the risk that the debt cannot be repaid. The assessment of this risk can be expressed in terms of an interest rate or any other mechanism by which accounts are adjusted to reflect such a (real) loss, once it is recognised. OTOH, a loss expected but not incurred is a (real) gain. These risks / rewards do not disappear if people change their preference over whether to hold their records in one type of account or another. So there is a kind of macro Miler Modigliani theorem at work concerning 'portfolio preferences'.

Without the system of record-keeping in place, goods would not need to be valued in terms of a UoA. The value of land, for example, would be restricted to its immediate use value (as a place for dwelling, subsistence farming, enjoying a view etc.) and could, to the extent that there is some kind of property right, be passed on, say from one generation to the next, without mention of an exchange value.

There are things (past, present or future) and there is a system by which we keep track of things changing owners.

I apologize for this question; I am not an economist. I am asking for your definition of ‘income’; it seems you are excluding so-called “capital gains.” My income for a certain period is not the change in my net worth. It is a factor—a component--in that change, but there are other factors, one of which is my capital gain (or loss). Are there other factors? Taxation? Theft? Dividends, interest, rents? Anything else?
If I sell my labor for wages(/salary), my wages are income. If I labor to repair my automobile, after which it is worth more than before, this is a capital gain, not income. If, instead of doing my own repair, I work overtime for pay and hire a mechanic to repair the car, I have more income (and, probably, so does the mechanic), though from my point of view the result is practically the same. If I write a novel, the labor of writing is uncompensated—like repairing my own auto—so, no income. If I then sell it to a publisher, I reap a capital gain—still not income. But if I was hired as a writer and paid by the hour, my writing would bring income.
Similarly for “entrepreneurial” activity: setting up and running my own business is, at least in part, creating a capital asset—thus, capital gain. But some of the labor of running the business can be passed off onto hired workers, while I spend the time I thereby save working for someone else for pay, which is income for me. If hire no employees in my business, some of my work, arguably, should be counted as labor, for which I am paying myself an implicit salary. But since the salary is only implicit, it is not income. (Can I make it explicit by reporting it to the taxing authority? What if there is no tax on businesses, thus no one to whom to report?)
I am hoping that your answer will make it clear whether “income” is a concept that is valuable for basic economic analysis, or whether, instead, it is an arbitrary social construct, of no theoretical importance.
(In the comments you question distinctions that seem fundamental to economic theory—consumption-goods/capital-goods and newly-produced/already-existing. Why does economics rest on such shaky distinctions?)

Oliver: thanks for the good comment. As you know, I disagree with your perspective, but it's still useful to be able to see things another way.

Philo: I have a *lot* of sympathy with your comment. Economists tend to divide up the world into certain categories, and it's not obvious to me that those categories make the most sense.

Here's one old post where I said something sorta similar:

And a second:

But let me try to take the other side, and defend the standard convention:

Macroeconomists are especially interested in the level of output -- production of new goods and services. So we define "income" and "expenditure" in such a way that we get the fundamental National Income Accounting identity:

Income = Output = Expenditure

So we can look at (and measure) the same thing in 3 different ways. And this is the way the data is collected, and we want our theories to define things in the same way the data collectors define them.

So capital gains can't count as income. And expenditure on used cars can't count as expenditure. Etc.

But in practice there are lots of difficult cases, especially where we can't measure things easily, so we end up with some rather arbitrary distinctions. Like home production of goods for your own use doesn't count. (Unless you're a farmer, in the US anyway!)

Part of the underlying problem is we sometimes want to think about goods that get exchanged, for money, separately from those that don't. Because exchange, and money, matter. But then some goods are produced that are not exchanged, and some goods are exchanged that are not (newly) produced.

The world is messy. Collecting data is messy. Trying to fit any system of clean theoretical categories on a messy world is hard.

Nick: I know, I'm not trying to convince you, but apparently cannot resist the urge to preach (to the ether?). I guess writing has a therapeutic effect and helps me structure my own thoughts.

Philo: I think this isn't true: If I write a novel, the labor of writing is uncompensated—like repairing my own auto—so, no income. If I then sell it to a publisher, I reap a capital gain—still not income.

As soon as you sell it, it counts as a type of income. The capital gain itself is just an increase in value of the asset, in this case the novel, which means you would need to have defined the value before and after for there to be a gain. Once you sell it, the gain is 'realized'. That realization is a type of income which is then taxed. Whether or not the gain before realization is also taxed, I don't know. That would be akin to a wealth tax, not an income tax.

I think you have to look at the economy in terms of 'economic units' that are sort of black boxes from a macro perspective. Such units may be households but also, e.g. your brain. I don't know how many times your girlfriend cleaned the house or how often you went shopping, nor do I know how many novels you have up your sleave. But as soon as you find a publisher to pay you for writing said novel, that transaction is measurable and has become part of the market. That's what the market is. You have sold your ideas and received an official, and thus taxable, income in exchange. If the publisher paid you cash, that payment would be 'off the grid' / hard to trace and you could probably smuggle it past the tax authorities. That's the problem with anonymous payment technologies such as cash.

There is much discussion about the value of unpaid care work. This value does not show up in any accounting frameworks because it is not officially recorded. See Wikipedia on Feminist Economics / Exclusion of non-market activity, for example.

Regarding Taxation. It's a question of: what do the authorities know, what can they know and at which point is it easiest for them and least disruptive for us to levy a tax. Transaction taxes such as income, sales etc. are good for the authorities because transactions are easy to identify and to measure. Not sure they're optimal in other senses. Transactions seems like something one might generally want to encourage, not discourage.

Regarding arbitrariness of the concept of income. Absolutely, but I'm also not sure that marketizing intra household activity would solve any problems. Could turn out to be pretty distopian if taken to its logical conclusion. But awareness of the limits of accounting concepts is never wrong. They are man-made, after all.

Philo: Oliver is right about the novel writing counting as income when you sell the novel. Weird thing is though, a firm's unsold inventories of newly-produced goods count as income, and investment expenditure. It's deemed to have sold those newly-produced goods to itself! That's the only way you can keep income=output=expenditure true.

a firm's unsold inventories of newly-produced goods count as income, and investment expenditure

I think you're missing a step.

My take (not an accountant): Wages and purchases of intermediate goods are expenses. If employees produce a good that can be stored, then the wage is assigned to the good. So, as viewed from the firm, the wage account is debited (employees' accounts are credited) and inventory is credited by the same amount. Once inventory is sold, then the sales account is credited and inventory is debited. Employees are not the property of a firm. They sell their output to the firm on a contractual basis (employment contract).

If you think of a firm that offers only services, then wages (and other expenses) are paid directly by customers. The firm is merely a legal construct that defines the rights and obligations of employees, management, creditors, equity and other stake holders, particularly wrt to who gets how much of what comes in and what happens when things go belly-up.

"2. Money. All assets are different, but the asset that gets used as Unit of Account and Medium of Exchange is more different than all the others."

So very true! But the distinction between "used as Unit of Account" and "Medium of Exchange" should not be a source of confusion.

When money is used as a UofA, it is being used to measure something. With measurement in hand, we can report a number.

When money is used as a MofE, it is being used as an asset. The exchange cannot happen unless one of the two exchangees has ownership of the exchanged money asset.

We can reinforce this distinction by thinking of other forms of measurement. A 12 inch ruler is a good comparison in the USA. Land is measured terms of rulers (OK, I know that one ruler is commonly considered as one foot in length). So we can say that a building lot measures 100 by 200 rulers in size.

What we don't do is to require ownership of rulers to prove measurement. Nor do we require ownership of money to prove Unit of Account.

We do require ownership to use money as a Medium of Exchange.

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