I tend to spend most of my time on Substack reading Tomas Pueyo's Uncharted Territories. We recently had a conversation about how writing helps thinking: you have to clarify and organise your thoughts to get them into written form. This means you can see them as another person might and gives you a different perspective. If you take a further step and try to teach someone about your writing, then that forces you to translate your thinking into simpler language and again makes your brain think about the issue in a different way. I think for various reasons economic concepts are made to sound very complicated when in fact they are not.
FWIW I will give you my thoughts on value, IOUs and savings*. The financial value of things changes all the time depending on supply and demand. I would argue that in an economic discussion, as Noah also argues, the only true value is the current market value i.e what someone else is prepared to pay at that particular point in time. Any other value is merely a notional value (what we would like to believe something is worth!). The value of a famous pen is higher simply because someone (logically or emotionally) will pay more for it than a standard pen. Ten minutes later it might be posted on social media that the famous person has been charged with rape and demand for (and thus financial value of) the famous pen evaporates. Some people understand this constant change in the value of things through concepts such as wealth creation and wealth destruction.
An IOU is a debt. If I have an IOU for a bulb from a shop then that is an asset, but it is not worth the same as an actual bulb in my possession because of credit risk. In the example you give, the credit risk is probably very low but not zero. If you call in the loan, what are the chances you will get 100% of what you are owed? Credit risk is simply a quantification of trust. Thinking clearly about this exposes a major flaw in our financial system’s balance sheets that has been exposed time and again by reality: if you account for an IOU as an asset, then in theory it should be discounted by some percentage due to credit risk.
If Bob has written Frank an IOU for a banana then clearly he is a debtor and this should appear as a liability on his balance sheet. It should appear on Frank’s balance sheet as an asset, but ideally discounted according to credit risk. I don’t think there is any practical advantage in using the word savings, I would just stick to the concept of assets and liabilities. The word savings implies an accumulation of assets over time, but there is no difference in theory between cash, gold, money in the bank or any other asset such as a pen or a light bulb. They all have advantages and disadvantages as a vehicle for saving that depend on the circumstances at the time. In a realistic world, assets would also be discounted by their loss risk: anything that you legally own can be taken away from you. It is only because we have lived in an age of peace and respect for property rights that some assets seem less risky than they actually are.
Thanks for making me think!
* This will of course help me clarify my thoughts and expose them to challenge. If there is an error of logic pointed out then I can learn from that and adjust my model of reality accordingly (i.e. learn and improve)
Aaargh! I just clicked on something and lost my long reply to you! :-(
Anyway, thanks very much for your thoughtful reply! I'll try to reproduce what I can remember of what I lost.
The reason I always talk about *raw* net worth (RNW = assets - liabilities) is because avoiding values removes any subjectivity from the model, and as a huge bonus makes for the only *linear* economic model which I'm aware of: (1) the RNW of a group of people is the exact sum of the RNWs of the individuals, and (2) the effect on an individual's RNW of a set of actions (arrows) is the exact sum of the effects of the individual actions. For example, imagine you start with 10 apples and $10. If you eat 2 apples, and I give you $5, you unambiguously end up with 8 apples and $15. I'm convinced this linearity makes economics into a true science.
I agree that credit risk and risk of loss are both important, but if you don't insist on the model attempting to *predict* what people will do, the state of the model at a given time doesn't *have* to reflect the effects of a potential *future* event, just like Newtonian mechanics doesn't consider the effects of potential future forces which aren't *currently* being exerted. Note that default and loss are both zero-sum actions (write-off and transfer of tangible/debt asset respectively). Recognising events such as defaults only at the point they happen, instead of beforehand, also makes the model extremely simple, without ignoring their existence.
The reason I'm talking about savings is that I believe the term is often used in a careless way which doesn't make sense, and can be extremely misleading (and make for bad policy recommendations). For example, there's a huge difference between (1) a debt for one banana owed by someone who has a banana which isn't owed to anyone else, and who is willing to hand it to the creditor in settlement of the debt, and (2) a debt for one banana owed by someone whose only means of settling it is imposing a debt for one banana on the creditor, and then cancelling this debt in exchange for the original debt being cancelled. (Bonus mark for working out what I'm alluding to here!)
In an isolated community (with no debts owed to or by anyone outside), the only credible definition of savings seems to be the RNW of the community (which is the sum of the tangible assets). Since the RNW of the community is the sum of the RNWs of the individuals, you can see an individual's RNW as their share of the total savings, but it's difficult to explain the reasoning clearly when someone owes something which they don't have a means of paying. That's why I've decided to leave it for now.
You may find this slightly older article interesting. I was discussing provisions for bad debt, as well as goodwill, etc.
My comment above was written in my best approximation of “economist-speak”. This reply is written more in plain English which I much prefer.
Are my eyes deceiving me or did I read the word “science” in your response? An economics discussion based on scientific principles??? Surely not! Imagine using the single most useful set of principles known to man on a subject as fundamental to human wellbeing as economics! Sounds like an eminently sensible idea to me. In truth economics is a hybrid between the mathematical/scientific part and the human psychology part, but these often seem to get mixed together and it seems more sensible to try separating the two as you are doing.
I like the RNW approach very much because it is based on the real world, not the fantasy land that many people discussing economics inhabit. It also gets to the heart of the matter and as you say avoids the issue of whose value judgement we rely on. I completely agree that the value of anything is subjective, it is different for different people and varies over time. Market value is less subjective than notional value, but can still be highly misleading depending on the structure and depth of the particular market.
On the savings question, I actually misread at first and so slightly misunderstood the original post about Frank and Bob. The RNW reality of the situation is that the asset Frank holds is simply an IOU for a banana from Bob. I think it is simpler to ignore any consideration of Bob’s assets for the reasons you clearly state when you explain the advantage of the RNW concept above: potential future events are unpredictable (particularly when talking about human behaviour). As soon as you start to consider any future repayment of the IOU then you get into complex questions like the ability and willingness of Bob to repay (i.e. is he a good credit risk?). He might have an apple right at this moment, but in 10 minutes’ time he might decide to eat it, he could lose it, have it stolen from him or he might just flee the country with it. Credit can be based on trust, but if Frank and Bob have never met then the legal system and its enforcement mechanisms become much more important factors.
Taking a scientific approach to any subject starts with clear definitions of terms, so I am interested in your thoughts on what constitutes a person’s assets (please feel free just to refer me to one of your posts if you’ve already covered this).
PS I share your pain at losing the original reply. I have learned from bitter experience to write any long reply as a Word document rather than on Substack itself!
PPS I’m not going to try for the bonus mark because at the moment I am time poor and the answer to that question is what I am hoping to get from your work (or Steve Keen’s). You take a bottom up approach as opposed to Steve’s top down approach, but both of you are keenly aware of the fact that current economic theory can’t explain or predict the reality of the financial world. Even the man on the street knows that something fishy is hidden in all those equations and complicated balance sheets, but he doesn’t have the knowledge or the words to bring it into plain sight. I’ve always been interested in history, including monetary history so I understand the steps that led to the modern financial system, I just don’t have a complete technical understanding of how things work these days.
"In truth economics is a hybrid between the mathematical/scientific part and the human psychology part, but these often seem to get mixed together and it seems more sensible to try separating the two as you are doing."
We seem to be on exactly the same wavelength. When I first came across economics, I thought there ought to be a part of it which was completely objective, but nobody seemed to be doing that. I suspect the reason is that when people looked for a way to apply maths to economics, they were looking for *numbers*, saw price as an extremely interesting and important phenomenon, and centred their analysis around that. But as you're saying, you can't have a model of prices without taking into account human psychology, because there are feedback loops: behaviour influences prices, and prices influence behaviour.
The quick answer to what constitutes assets is: the things which you own (tangible assets) plus the things which you're owed (debt assets). And liabilities are the things which you owe. A friend of mine got me thinking about this in a bit more depth, asking whether knowledge/understanding, health, or friends are assets. My conclusion is that, when we're studying economics, what counts for assets is the things which you can assign to someone else, so knowledge, health and friends don't count as assets. (I'm not saying they're unimportant!)
If you have an hour, you might find Lecture 3 of Perry Mehrling's Economics of Money and Banking series particularly useful for monetary theory, especially once it gets to Part 4 where he starts showing balance sheets:
Thanks, I will have a look at that lecture and your double entry bookkeeping post when I can free up some time and brain space to do them justice.
My take on assets is that they are things which a person owns that can be traded with someone else. The most valuable asset that young adults own is themselves (unless they are a slave or have been given a massive inheritance). Thus they can trade their physical labour, intellectual ability, knowledge or even their body (should morals allow it) with other people in exchange for something they value. People don’t own their health or their friends so they can’t sell them, but knowledge and skills are definitely things that a person possesses that can be sold. Alas our body is depreciating asset so needs constant input to maintain health. We know this, so smart people try to accumulate savings with a view to retirement.
Prices are definitely an objective mathematical thing and at the heart of economics. I still agree with Noah that they are the best (really the only) objective measure of value that we have available, but they can be misleading for all sorts of reasons. I see the scientific part as understanding those reasons then having a clear, open and honest discussion about them. One crucial step in the scientific process is definition of terms, the next crucial element is measurement. We define a metre incredibly precisely as the length of the path travelled by light in vacuum during a time interval of 1/299792458 of a second. This is kind of important when building a bridge that you want to stay standing for a while. But what do economists use as their measuring stick? Money. So questions like “what is money?” and “how much of it is there in the world?” are fundamental to the accurate measurement that science requires. If you use an elastic measuring tape then the all the complicated maths in the world can’t correct for the measurement error and your conclusions will be horribly wrong.
The obvious question in the 21st century is why economists persist with unscientific thinking. I think the answer is that economics has a very long history that is deeply entwined with politics. We have recently seen what happens when science becomes politically important (climate change and Covid policies): the debate rapidly becomes very unscientific.
In writing this post several interesting questions have popped into my head that I need to think about some more, so we seem to have come full circle to The Importance of Writing. Thanks for making me think!
I tend to spend most of my time on Substack reading Tomas Pueyo's Uncharted Territories. We recently had a conversation about how writing helps thinking: you have to clarify and organise your thoughts to get them into written form. This means you can see them as another person might and gives you a different perspective. If you take a further step and try to teach someone about your writing, then that forces you to translate your thinking into simpler language and again makes your brain think about the issue in a different way. I think for various reasons economic concepts are made to sound very complicated when in fact they are not.
FWIW I will give you my thoughts on value, IOUs and savings*. The financial value of things changes all the time depending on supply and demand. I would argue that in an economic discussion, as Noah also argues, the only true value is the current market value i.e what someone else is prepared to pay at that particular point in time. Any other value is merely a notional value (what we would like to believe something is worth!). The value of a famous pen is higher simply because someone (logically or emotionally) will pay more for it than a standard pen. Ten minutes later it might be posted on social media that the famous person has been charged with rape and demand for (and thus financial value of) the famous pen evaporates. Some people understand this constant change in the value of things through concepts such as wealth creation and wealth destruction.
An IOU is a debt. If I have an IOU for a bulb from a shop then that is an asset, but it is not worth the same as an actual bulb in my possession because of credit risk. In the example you give, the credit risk is probably very low but not zero. If you call in the loan, what are the chances you will get 100% of what you are owed? Credit risk is simply a quantification of trust. Thinking clearly about this exposes a major flaw in our financial system’s balance sheets that has been exposed time and again by reality: if you account for an IOU as an asset, then in theory it should be discounted by some percentage due to credit risk.
If Bob has written Frank an IOU for a banana then clearly he is a debtor and this should appear as a liability on his balance sheet. It should appear on Frank’s balance sheet as an asset, but ideally discounted according to credit risk. I don’t think there is any practical advantage in using the word savings, I would just stick to the concept of assets and liabilities. The word savings implies an accumulation of assets over time, but there is no difference in theory between cash, gold, money in the bank or any other asset such as a pen or a light bulb. They all have advantages and disadvantages as a vehicle for saving that depend on the circumstances at the time. In a realistic world, assets would also be discounted by their loss risk: anything that you legally own can be taken away from you. It is only because we have lived in an age of peace and respect for property rights that some assets seem less risky than they actually are.
Thanks for making me think!
* This will of course help me clarify my thoughts and expose them to challenge. If there is an error of logic pointed out then I can learn from that and adjust my model of reality accordingly (i.e. learn and improve)
Aaargh! I just clicked on something and lost my long reply to you! :-(
Anyway, thanks very much for your thoughtful reply! I'll try to reproduce what I can remember of what I lost.
The reason I always talk about *raw* net worth (RNW = assets - liabilities) is because avoiding values removes any subjectivity from the model, and as a huge bonus makes for the only *linear* economic model which I'm aware of: (1) the RNW of a group of people is the exact sum of the RNWs of the individuals, and (2) the effect on an individual's RNW of a set of actions (arrows) is the exact sum of the effects of the individual actions. For example, imagine you start with 10 apples and $10. If you eat 2 apples, and I give you $5, you unambiguously end up with 8 apples and $15. I'm convinced this linearity makes economics into a true science.
I agree that credit risk and risk of loss are both important, but if you don't insist on the model attempting to *predict* what people will do, the state of the model at a given time doesn't *have* to reflect the effects of a potential *future* event, just like Newtonian mechanics doesn't consider the effects of potential future forces which aren't *currently* being exerted. Note that default and loss are both zero-sum actions (write-off and transfer of tangible/debt asset respectively). Recognising events such as defaults only at the point they happen, instead of beforehand, also makes the model extremely simple, without ignoring their existence.
The reason I'm talking about savings is that I believe the term is often used in a careless way which doesn't make sense, and can be extremely misleading (and make for bad policy recommendations). For example, there's a huge difference between (1) a debt for one banana owed by someone who has a banana which isn't owed to anyone else, and who is willing to hand it to the creditor in settlement of the debt, and (2) a debt for one banana owed by someone whose only means of settling it is imposing a debt for one banana on the creditor, and then cancelling this debt in exchange for the original debt being cancelled. (Bonus mark for working out what I'm alluding to here!)
In an isolated community (with no debts owed to or by anyone outside), the only credible definition of savings seems to be the RNW of the community (which is the sum of the tangible assets). Since the RNW of the community is the sum of the RNWs of the individuals, you can see an individual's RNW as their share of the total savings, but it's difficult to explain the reasoning clearly when someone owes something which they don't have a means of paying. That's why I've decided to leave it for now.
You may find this slightly older article interesting. I was discussing provisions for bad debt, as well as goodwill, etc.
https://economics21st.substack.com/p/double-entry-bookkeeping-3
Anyway, it was a pleasure to hear from you. I'm always happy to reply to comments!
My comment above was written in my best approximation of “economist-speak”. This reply is written more in plain English which I much prefer.
Are my eyes deceiving me or did I read the word “science” in your response? An economics discussion based on scientific principles??? Surely not! Imagine using the single most useful set of principles known to man on a subject as fundamental to human wellbeing as economics! Sounds like an eminently sensible idea to me. In truth economics is a hybrid between the mathematical/scientific part and the human psychology part, but these often seem to get mixed together and it seems more sensible to try separating the two as you are doing.
I like the RNW approach very much because it is based on the real world, not the fantasy land that many people discussing economics inhabit. It also gets to the heart of the matter and as you say avoids the issue of whose value judgement we rely on. I completely agree that the value of anything is subjective, it is different for different people and varies over time. Market value is less subjective than notional value, but can still be highly misleading depending on the structure and depth of the particular market.
On the savings question, I actually misread at first and so slightly misunderstood the original post about Frank and Bob. The RNW reality of the situation is that the asset Frank holds is simply an IOU for a banana from Bob. I think it is simpler to ignore any consideration of Bob’s assets for the reasons you clearly state when you explain the advantage of the RNW concept above: potential future events are unpredictable (particularly when talking about human behaviour). As soon as you start to consider any future repayment of the IOU then you get into complex questions like the ability and willingness of Bob to repay (i.e. is he a good credit risk?). He might have an apple right at this moment, but in 10 minutes’ time he might decide to eat it, he could lose it, have it stolen from him or he might just flee the country with it. Credit can be based on trust, but if Frank and Bob have never met then the legal system and its enforcement mechanisms become much more important factors.
Taking a scientific approach to any subject starts with clear definitions of terms, so I am interested in your thoughts on what constitutes a person’s assets (please feel free just to refer me to one of your posts if you’ve already covered this).
PS I share your pain at losing the original reply. I have learned from bitter experience to write any long reply as a Word document rather than on Substack itself!
PPS I’m not going to try for the bonus mark because at the moment I am time poor and the answer to that question is what I am hoping to get from your work (or Steve Keen’s). You take a bottom up approach as opposed to Steve’s top down approach, but both of you are keenly aware of the fact that current economic theory can’t explain or predict the reality of the financial world. Even the man on the street knows that something fishy is hidden in all those equations and complicated balance sheets, but he doesn’t have the knowledge or the words to bring it into plain sight. I’ve always been interested in history, including monetary history so I understand the steps that led to the modern financial system, I just don’t have a complete technical understanding of how things work these days.
"In truth economics is a hybrid between the mathematical/scientific part and the human psychology part, but these often seem to get mixed together and it seems more sensible to try separating the two as you are doing."
We seem to be on exactly the same wavelength. When I first came across economics, I thought there ought to be a part of it which was completely objective, but nobody seemed to be doing that. I suspect the reason is that when people looked for a way to apply maths to economics, they were looking for *numbers*, saw price as an extremely interesting and important phenomenon, and centred their analysis around that. But as you're saying, you can't have a model of prices without taking into account human psychology, because there are feedback loops: behaviour influences prices, and prices influence behaviour.
The quick answer to what constitutes assets is: the things which you own (tangible assets) plus the things which you're owed (debt assets). And liabilities are the things which you owe. A friend of mine got me thinking about this in a bit more depth, asking whether knowledge/understanding, health, or friends are assets. My conclusion is that, when we're studying economics, what counts for assets is the things which you can assign to someone else, so knowledge, health and friends don't count as assets. (I'm not saying they're unimportant!)
If you have an hour, you might find Lecture 3 of Perry Mehrling's Economics of Money and Banking series particularly useful for monetary theory, especially once it gets to Part 4 where he starts showing balance sheets:
https://www.youtube.com/playlist?list=PLmtuEaMvhDZZyyAkEniNUMTTnlJj6qiKW
Thanks, I will have a look at that lecture and your double entry bookkeeping post when I can free up some time and brain space to do them justice.
My take on assets is that they are things which a person owns that can be traded with someone else. The most valuable asset that young adults own is themselves (unless they are a slave or have been given a massive inheritance). Thus they can trade their physical labour, intellectual ability, knowledge or even their body (should morals allow it) with other people in exchange for something they value. People don’t own their health or their friends so they can’t sell them, but knowledge and skills are definitely things that a person possesses that can be sold. Alas our body is depreciating asset so needs constant input to maintain health. We know this, so smart people try to accumulate savings with a view to retirement.
Prices are definitely an objective mathematical thing and at the heart of economics. I still agree with Noah that they are the best (really the only) objective measure of value that we have available, but they can be misleading for all sorts of reasons. I see the scientific part as understanding those reasons then having a clear, open and honest discussion about them. One crucial step in the scientific process is definition of terms, the next crucial element is measurement. We define a metre incredibly precisely as the length of the path travelled by light in vacuum during a time interval of 1/299792458 of a second. This is kind of important when building a bridge that you want to stay standing for a while. But what do economists use as their measuring stick? Money. So questions like “what is money?” and “how much of it is there in the world?” are fundamental to the accurate measurement that science requires. If you use an elastic measuring tape then the all the complicated maths in the world can’t correct for the measurement error and your conclusions will be horribly wrong.
The obvious question in the 21st century is why economists persist with unscientific thinking. I think the answer is that economics has a very long history that is deeply entwined with politics. We have recently seen what happens when science becomes politically important (climate change and Covid policies): the debate rapidly becomes very unscientific.
In writing this post several interesting questions have popped into my head that I need to think about some more, so we seem to have come full circle to The Importance of Writing. Thanks for making me think!