Paul Krugman on Monday delivered an excellent primer on basic economics and the importance of what economists call accounting identities.
His key point is that just as 2+2=4, for economies as a whole spending=income.
“If everyone tries to slash spending at the same time, incomes will fall—and unemployment will soar,” Krugman noted, as it did in the Great Recession.
News reports often liken government finance to family budgets, but Krugman reminds us “an economy is not like a household.” Among other things, the federal government can create money, while households can only earn more or spend less.
That America remains in the economic doldrums makes it “tempting to argue that the economic failures of recent years prove that economists don’t have the answers,” Krugman wrote, adding, “the truth is actually worse: in reality, standard economics offered good answers, but political leaders—and all too many economists—chose to forget or ignore what they should have known.”
Central to understanding standard economics are accounting identities, which regardless of ideology or viewpoint are, and must be, true.
Economist Dean Baker, who blogs about economic coverage, has long made the same point—that journalists covering the economy and public finance should check their work against standard accounting identities to avoid conceptual error. As he wrote for the British newspaper The Guardian in 2010:
There are few areas of economics more boring than accounting identities. This is really unfortunate, since it is virtually impossible to have a clear understanding of economic policy without a solid knowledge of the underlying identities.
Most of the people in Washington policy debates were apparently overcome by boredom before they could get this knowledge. As a result, we see some really silly policy debates.
Baker sometimes uses accounting identities to show factual problems in news reports and opinion columns, though the algebra is not always so simple as spending=income.
Peter Dorman, who teaches economics at Evergreen State in Washington, has also cautioned about commenting on reducing fiscal deficits “without regard to fundamental accounting identities.”
Dorman points out that private and government debt cannot be simultaneously reduced (except through infusions of foreign earnings), because “one person’s debt is another’s asset.”
Matthew Yglesias has also shown the relevance of accounting identities, noting that they are not causal theories, but equations that must be true.
My own explanation of these economic basics is available in text
and video.
