Does Saving “Fund” Investment?

If this blog has any tiny claim to any important influence, it might be that anonymous and magisterial commenter JKH used the comments section here to first bruit his insight (both tautological and profound) that S = I + (S – I).

He revisited that construct and concept again recently, and I’ll leave it to you to explore his very interesting thinking.

But I do want to address a central issue in that discussion: the notion of “funding.”

JKH quite properly uses standard flow-of-funds accounting terminology to explain that private-sector “saving” “funds” both its “investment” (buying/creating drill-presses and such), and its acquisition of newly created financial assets.

Quite properly, but: it’s important to understand what that key accounting verb (“funds”) actually means. It describes an after-the-fact and arguably largely arbitrary accounting allocation of income streams to outflow streams.

Imagine 2011, a year in the life of BFC Corp.:

INFLOWS
Profits (revenues – expenses): $100,000
Net Borrowing (borrowing – loan payoffs): $100,000

OUTFLOWS
Investment (spending on drill presses and such): $100,000
Dividends paid to shareholders: $100,000

Looking back: Of the $200K in inflows, which part “funded” the investment spending on drill presses? What funded the dividend payout? The accountant’s allocation decision, absent any other information, is after-the-fact and completely arbitrary. Funds are fungible — especially when viewed in retrospect.

Before-the-fact conditions and restrictions might well give justification for a given after-the-fact accounting allocation decision. If BFC decided in 2010 to spend X% of profits on drill presses in 2011, and that X% came to $100,000, an accountant after the fact might quite reasonably say that the drill-press purchases were “funded” by that year’sprofits.

Alternately: Imagine BFC “set aside” $100,000 from 2010 profits for future drill-press purchases by “funding” a drill-press holding account on their books, debiting their 2010 profits to “fund” that holding account. (Maybe it even created an actual external bank account to hold and segregate those funds, though that’s not actually material to this discussion.) It then spent down that holding account in 2011 to buy drill presses. Were those purchases “funded” by 2011 profits or borrowing? The proper accounting answer here is “neither.” Looking backwards you might/could/would say that they were funded, ultimately if somewhat arbitrarilly, from 2010 profits, or from the holding account. Either is accurate, depending on how you telescope your “funding” pipeline, in both time and account-space. (This is all rather like discussions of the Social Security Trust Fund.)

When we say, in a backward-looking flow-of-funds statement, that “X funded Y,” that is an ex-post description that is informed, and arguably justified — but not fully or authoritatively determined — by knowledge of before-the-fact intentions.

So when we say that “…the marginal dollar borrowed by a nonfinancial business [post-’85] was simply handed on to shareholders, without funding any productive expenditure at all,” we are making a statement about what “funds” what. We’re saying that all the borrowing went to payouts, and all the profits went to investment. The reverse could be equally accurate, given that shareholders from ’04 to ’08 were paid about $200 billion more than their companies earned in profits.

Let’s try this on the level of national/international accounts, and sectoral flows. Here’s mythical 2011 accounting for Bandalaria:

Assume (purely for simplicity in explaining the “funding” concept) that:

1. There is no net trade surplus or deficit, and the country’s capital account balance sheet remains unchanged.

2. The central bank does not increase or decrease its holdings on net.

3. The financial system does not increase or decrease its loan book to the private sector.

That leaves two sectors, with (looking back) no accounting impact from the above:

• Federal government (Treasury)

• The nonfinancial private sector (nonfinancial firms and households)

What do Bandalaria’s net money flows look like?

From Treasury -> Private
Deficit (purchases minus taxes): $100 million

From Private -> Treasury
Treasury bond purchases : $100 million

Looking back, how would you describe these flows? Are are the bond purchases “funding” the deficit, or is the deficit spending “funding” the bond purchases?

The correct answer is “Yes.”

Likewise: when JKH says (my words actually) that saving (income – expenditure) by the private domestic nonfinancial sector “funds” both its investment spending and its net acquisition of new financial assets (including government bonds), his description is perfectly correct.

But he would equally correct if he said that government deficits (less trade deficits) “fund” some of the investment, or (all of) the acquisition of new financial assets (notably government bonds), by the private domestic nonfinancial sector (or some of each).

Obviously, the two accounting-based descriptions, both accurate, have very different rhetorical implications.

This just reiterates the point I made in the post to which JKH responded with his revelatory identity: accounting tells us nothing about economics, except that it often tells us when economic thinking doesn’t make any logical/arithmetic sense.

I guess my main point here, perhaps obvious to many, is that accounting descriptions — choices about how to describe the past in accounting-speak, especially regarding “saving” and “funding” — are, inevitably, rhetorical hence normative. Or at least, those choices of descriptions have inevitable rhetorical hence normative implications.

Or to put it simply: accounting is normative.

My impression is that many economic discussions and disagreements, especially in the “MM” worlds, are at their root disagreements about what “funds” what (frequently compounded by imprecise sector definitions with different parties using different implicit definitions), and the rhetorical hence normative implications of those competing descriptions.

Cross-posted at Angry Bear.


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6 responses to “Does Saving “Fund” Investment?”

  1. Nathan Tankus Avatar

    good post. I was making precisely this point in an MMT/post keynesian forum yesterday. I would go further then you though. at one point JKH said:

    “And that is the equation in question. It says that private sector saving is the amount required to fund investment I plus a residual amount in excess of that, equal to (S – I). ”

    you could use this description for all sorts of derivations of the accounting identities. see below:

    “And that is the equation in question. It says that tax revenues is the amount required to fund government spending G plus (minus) a residual amount in excess (below) that, equal to (T – G). ”

    “And that is the equation in question. It says that imports is the amount required to fund exports X plus (minus) a residual amount in excess (below) that, equal to (M – X). ”

  2. DkN Avatar
    DkN

    Nice post

    Have you read this?

    Fabien Linder:

    “Saving does not finance
    Investment:
    Accounting as an indispensable
    guide to economic theory”

    http://www.boeckler.de/pdf/p_imk_wp_100_2012.pdf

  3. Asymptosis Avatar

    @Nathan Tankus Nice! Gotta be careful when making assertions about what “funds” what.

    @DkN Thanks!! I will devour that soon.

  4. JKH Avatar
    JKH

    Hi Steve,

    Thanks for this.

    I only saw it a few days ago (I usually DO check in at your site more often, but am currently cramped by unusual space/time limitations).

    Agree in general, with minor quibbles on small stuff.

    (Thinking about doing a post on this, but present logistics preclude right now.)

    So, quick comment:

    ……..

    You said:

    ´´Looking back, how would you describe these flows? Are are the bond purchases “funding” the deficit, or is the deficit spending “funding” the bond purchases?

    The correct answer is “Yes.”

    Likewise: when JKH says (my words actually) that saving (income – expenditure) by the private domestic nonfinancial sector “funds” both its investment spending and its net acquisition of new financial assets (including government bonds), his description is perfectly correct.

    But he would equally correct if he said that government deficits (less trade deficits) “fund” some of the investment, or (all of) the acquisition of new financial assets (notably government bonds), by the private domestic nonfinancial sector (or some of each).´´

    …..

    The funding perspective I´ve alluded to is a RHS/LHS balance sheet deal, using normal flow of funds orientation. The defined balance sheet defines the scope.

    In the case of the investment/saving example, it is RHS equity that funds LHS investment and net financial assets. No further decomposition is necessarily implied in that alone, although it is feasible on a consistent basis, I think, as I note further below. Your examples are partly about arbitrary decomposition, but that doesn´t necessarily apply to the way I originally intended the application of the banking idea to investment/saving.

    At the micro banking level, which was the original application, the term ´´funding´´ was also intended to convey the idea of competition for different amounts and forms of liabilities, once the ´´loans create deposits´´ dynamic (and/or acquistion of assets creates liabilities more generally) has taken place as a macro banking balance sheet expansion/origination dynamic.

    You´ve taken it down to the asset-liability instrument level, which was not my original intention/use in transferring this idea to investment/saving.

    But, for example, where I might do something similar to the case for banking is with reference to the liability profile for cumulative deficit financing. E.g. if the entire effect was to alter the mix of reserves (as in QE), notes, bills, and bonds, for a GIVEN level of cumulative deficit financing, then I might use the term in a similar way as I did for bank liability management.

    Also, I´d say (not quite symmetrically) that loans create deposits and deposits fund loans; and deficit spending and investment spending jointly create private sector equity, and private sector equity jointly funds deficits and investment. Thats not symmetric because the banking transaction is a non-income/saving transaction that exists only in terms of financial intermediation, whereas the deficit/investment/saving dynamic has a conceptual income oriented existence prior to considering the dimension of financial intermediation.

    To get more symmetry in the comparison, I´d then boot the equity piece one rung higher to include financial intermediation – where it becomes a bit more analogous to banking – with the choice of funding instruments for both the deficit and investment pieces on both a flow and stock basis.

    At an institutional level, the private sector investment/saving balance sheet can still be separated from the government net liability balance sheet. So there is institutional balance sheet coherence in the use of the term funding on a RHS/LHS basis.

    Anyway, the above is all very imperfect due to current time/space constraints, and I really should do a post on it. (I wouldn´t be able to do that until later in April.) But you raise a very good and fundamental point, so I wanted to give you something on it, even if quick and somewhat garbled right now. I´d tweak the illustration of your general point a bit, because I don´t think your general point (or what I would prefer to think of selfishly as your general point) should be necessarily inconsistent with my approach. I imagine if you are able to respond here – on a post-incremental-push-up basis – that could very well provide impetus for my own post on this subject a bit later!

    🙂

  5. Tom Hickey Avatar

    @ JKH

    Look forward to your post. I think I am getting to understand this terminology. Thanks.

  6. Asymptosis Avatar

    @JKH:

    I’m really sorry I haven’t responded on this. As usual, I’m dying to hear your thoughts on this and other.

    Problem is, I really feel flummoxed by your deep reply (my dimwittedness), sort of flailing in trying to respond coherently.

    “The defined balance sheet defines the scope.”

    This is very useful though I have to internalize it. What do “defined balance sheet” and “scope” mean? Does it mean something like “relative to Sector X’s balance sheet”?

    “Thats not symmetric because the banking transaction is a non-income/saving transaction that exists only in terms of financial intermediation, whereas the deficit/investment/saving dynamic has a conceptual income oriented existence prior to considering the dimension of financial intermediation.”

    Making several conceptual jumps here, I think the asymmetry is because: 1. real goods require real resources (including labor) as inputs; financial assets don’t (or tiny amounts relative to market value), and 2. financial assets can’t be consumed; and 3. a purchase of real goods *requires* increased production; not true of financial assets, because they aren’t consumed.

    I’m working on yet another saving investment post (spurred on to finish it by Bill Woolsey’s wednesday post), and would love to query you on/discuss some stuff. Any place I could do that without displaying my gross ignorance to the world (yet)?