Tuesday, October 26, 2010

When Accounting Identities Are Useful

Sometimes people reject accounting identities in economics, such as the GDP formula Y=C+I+G+NX or the fact that current account deficits/surpluses means equal size net capital inflow/outflow which can be written as CAB=-NCF (CAB stands for current account balance, while NCF stands for net capital[in]flow), as being "empty tautologies".

However, while they can be (and often are) misinterpreted, they are in certain contexts useful in understanding the economy-and dispelling myths.

One example of this can be seen in this protectionist article. The article has many other outright false or half-true but misleading statements that I won't bother to refute as it is besides the point of this post. Instead I want to focus on the fact that the author first claims (correctly) that the U.S. runs a trade deficit and then claims (incorrectly) that the U.S. suffers from capital outflows.

The latter statement is extremely misleading because while some Americans invest in other countries, these investments are far smaller than the investments of non-Americans in America. And as the accounting identity CAB=-NCF shows, this must necessarily be the case as long as America has a current account deficit. Thus, if it is true as the author of the article claims that capital flows benefits the receiving countries at the expense of the countries from where they claim, than this point is a pro-American argument for free trade.

If you are aware of this accounting identity, you will easily see through this kind of nonsense, and that is one example of when accounting identities can be usefuul.