Money and Macroeconomics from First Principles, for Elon Musk and Other Engineers
Chapter 02: The First Principles of Money
I am releasing one chapter from this book every Friday. The previous introductory chapter is here:
https://profstevekeen.substack.com/p/money-and-macroeconomics-from-first
Double-entry bookkeeping has a conservation law, which accountants call “the Accounting Equation”. They express this as “Assets equal Liabilities plus Equity”, but it is better expressed in conservation form:
When restricted to financial assets—which are claims that an entity has on other entities—this leads to an economic-system-wide conservation law: the sum of all financial assets and liabilities is zero.[1]
This can be used to enable monetary macroeconomic analysis, by aggregating the many billions of transactions that occur over a year.[2] Figure 3 shows a trivially simple monetary transactions table with just two flows: firms paying wages to workers, and workers buying goods from firms.
Figure 3: A simple transactions table for Private Banks
Figure 3 shows the transactions from the banking system's perspective, for which the deposit accounts of Firms and Households are liabilities. For a complete picture, you need to see the transactions from the perspectives of the Firms and Households as well—and the Central Bank, since Reserves, which are an asset of the Private Banks, are a liability of the Central Bank. That results not merely in double-entry, but sextuple-entry, as shown by Figure 2: each of the two flows is shown six times.[3]
Figure 4: The full set of transaction tables
These tables generate systems of differential equations describing the dynamics of money. Each column is a stock; each row is a flow. The rate of change of each stock is therefore the symbolic sum of the relevant rows:
This makes it possible to develop economic models from these tables, by defining these flows in terms of each other and relevant parameters. I have implemented this in the program Ravel, using the same approach as Matlab does with Simulink: flowcharts are used to generate equations for numerical simulation.[4] Figure 5 shows the flowchart equations for this simple model. Stocks and flows are shown in red, and parameters in blue:
Figure 5: The flowchart equations needed to enable simulation of the model in Equation 2
Ravel generates the equations shown in Equation from the flowchart equations in Figure 3:[5]
Parameters can be varied during a simulation run, as shown in Figure 6.
Figure 6: The impact of varying parameters on the model
This technology can be used to assess the claim that you (and many others) have made, that America faces a crisis unless government spending is reduced:
America is going bankrupt extremely quickly. The interest payments on the national debt just exceeded the defense budget. They are over a trillion dollars a year just in interest and rising.[6]
In the next chapter, I use Ravel to see whether this assertion is correct. The answer depends on which model of the monetary system you believe describes the real world.
There are two opposing models:
Loanable Funds, in which banks function as intermediaries between savers and borrowers, which is taught by almost all economics textbooks—see for example (Mankiw 2016, pp. 71-77), (Samuelson and Nordhaus 2010, pp. 454-465); and
“Endogenous money” (McLeay, Radia, and Thomas 2014, p. 15), in which banks create money by creating debt, which is endorsed by the Bank of England (McLeay, Radia, and Thomas 2014), the Bundesbank (Deutsche Bundesbank 2017), and can be traced back to Irving Fisher (Fisher 1932, p. 15) and Joseph Schumpeter (Schumpeter 1954, pp. 1110-1117)
The crisis you envisage is inevitable under Loanable Funds.
[1] Nonfinancial assets, such as houses, factories and patents, are assets to their owners and liabilities to no-one. See https://www.investopedia.com/terms/n/nonfinancialasset.asp.
[2] A year is the appropriate time unit to use for economic analysis.
[3] Flows are shown using plus and minus notation, in place of CR and DR. The equation at the end of each row takes the place of the requirement for each line to contain a CR and DR entry.
[4] I am Ravel’s designer. The program is coded by my partner Russell Standish, whose PhD is in physics—see https://hpcoders.com.au/currvit.html.
[5] The equations can be exported in LaTeX and Matlab formats.
All of your accounting is valid, except it assumes private money creation can only be indebtedness. That expresses the current monopoly monetary paradigm of Debt ONLY, and that monopoly concept must be directly broken up with MONETARY GIFTING utilizing equal debits and credits that sum to zero at strategic points in the economic process like retail sale and point of loan signing. This supplemental accounting could be done by either the central bank or the government.