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Pragmatic Capitalism

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Understanding Flow of Funds Accounting

After the post a few weeks ago where I showed that Post-Keynesian Stock Flow Consistent modeling has become very popular on Wall Street I got a ton of emails asking for more details on this approach. So, here’s a short description and a few good links for you to explore if you’d like.

Stock flow consistent modeling is a form of economic modeling that involves a comprehensive macro framework for understanding the integration of the stocks and flows in the economy between its various sectors. This modeling is a top down approach that can involve a comprehensive macro view including a few sectors (such as the government and non-government) or a much more intricately detailed view including as many sectors as one wants to model, but usually modeling the most important sectors such as households, non-financial businesses, financial businesses, government and rest of world.

Although the term “stock flow consistent” has become popularized by Post-Keynesian Economists, it’s really just macro integrated accounting. So, please don’t confuse “Post-Keynesian” as having a monopoly on macro accounting or flow of funds accounting frameworks.  In fact, if you’ve ever cracked the Federal Reserve’s Z.1 report, probably the most important data set the US government compiles for the economy and the source of much of the St Louis Fed’s FRED database, then you’ve dabbled in “stock flow consistent” modeling which is more commonly referred to as “flow of funds” accounting by the Fed.  This approach to economic modeling was introduced by Morris Copeland in the 1940s when he brought it to the Federal Reserve.¹ Although it is widely used in the Fed and on Wall Street it hasn’t made much impact on more mainstream academic economic modeling techniques for reasons I don’t fully know. Copeland was famously critical of mainstream economic models that didn’t include money and were not consistent with macro accounting principles:

“I have said that the subject of money and moneyflows lends itself to a social accounting approach. Let me go one step farther. I am convinced that only with such an approach will economists be able to rid this subject of the quackery and misconceptions that have hitherto been prevalent in it.”²

I think Copeland has been proven correct as the financial crisis proved that leaving debt and money out of an economic model was wrong. I’d further add that a rudimentary understanding of banking and reserve accounting is crucial for understanding things like debt dynamics and monetary policy. I believe that this approach would have helped many mainstream economists avoid poor predictions about the impact of QE, the recent household deleveraging, inflation, etc. After all, my predictions following the GFC about low interest rates, low inflation, minimal impact from QE, etc. all stem from a rather basic flow of funds accounting methodology.

I’ll save the more complex modeling techniques for a future post, but here’s a simple example of understanding how flow of funds accounting can be applied to macroeconomic prediction making. Let’s say we have an economy operating in a deleveraging environment where households are debt constrained and the economy is in recession where asset prices are declining and the Central Bank implements QE (think 2008).  We’ll assume all else being equal except the new addition of QE to this environment. We can look at a simple flow of funds to understand what might happen here.  To keep things simple, we’ll implement our QE through the banks:

Bank sells $100 in t-bonds to Fed

Federal Reserve balance sheet:

Change in Assets = +$100

Change in Liabilities = +$100

Change in Net Worth = $0

Banks balance sheet:

Change in Assets = $0 (t-bond is swapped for reserves)

Change in Liabilities = $0

Change in Net Worth = $0

What happens here is an expansion of the Central Bank’s balance sheet which results in the flow of new reserves into the private sector and a flow of T-Bonds out of the private sector. This alters the composition of the private sector’s balance sheet, but not its size.  So, if we understand endogenous money (the fact that banks don’t lend out reserves) then it’s easy to conclude a few things here:

  1. Banks won’t necessarily increase credit expansion due to having more reserves because that’s not how banks make new loans.
  2. The size of the private sector’s balance sheet is unchanged therefore we shouldn’t expect dramatic changes in future spending since spending is a function of income relative to desired saving.
  3. Inflation likely won’t rise by much as a result of QE and therefore we also shouldn’t expect long-term interest rates to move much.
  4. QE changes the composition of financial assets by reducing the quantity of safe high interest bearing assets which could entice investors to increase their demand for other types of income generating alternatives.
  5. Aggregate income to the private sector is lower as QE reduces the amount of income paid to the private sector when it takes the T-Bond out.  This means QE, all else being equal, is likely deflationary in the long run when we’re in a low short-term interest rate environment.

From there we can apply all sorts of different probabilistic outcomes to QE and any exogenous shocks to our simple model. This is obviously very simplified, but you can see how this sort of flow of funds thinking is highly relevant for understanding how a policy measure might have a discernible transmission mechanism through the economy.

Over time, the development of flow of funds modeling has since been expanded on from Nobel Prize winner James Tobin to Wynne Godley to Marc Lavoie to Jan Hatzius and many others. I suspect that these approaches will be embedded increasingly into mainstream models over the coming years as their popularity on Wall Street makes them essential learning for any economist or market analyst who is trying to profit from a more realistic application of their understandings.

I basically view the monetary system as a bunch of spreadsheets showing relationships between the financial world and the non-financial world. Accounting is, in my opinion, the language of economics so if you don’t speak accounting you’ll have a tough time understanding the economy.  I won’t get overly detailed here, but I basically like to think of flow of funds accounting as a much larger version of any sort of accounting that we more commonly use.  For instance, if you want to understand your financial situation during the year you don’t theorize about supply/demand curves and write fancy mathematical equations. No, you write up an income statement and a balance sheet and then the IRS takes 39.6% of your money for doing so. Flow of funds accounting is just a much more macro version of this.

So, any time you think of a company’s income statement or balance sheet accounting, earnings reports, analysts reports, your taxes, government accounting reports, Federal Reserve audits, etc, you can think of flow of funds accounting as taking all of those balance sheets or income statements and integrating them into one big macro framework to help you understand how they’re related. For the purpose of macro financial analysis it’s truly essential and anyone who rejects it is just rejecting a macro version of micro things we all use regularly when we’re trying to understand the financial world.

If you want to get more complex I would recommend exploring some of the following resources:

¹ – Copeland, Morris. (1942). Some Illustrative Analytical Uses of Flow-of-Funds Data.

² –  Ramanan, V.  Flow Of Funds And Keynesian Macroeconomics

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