Stocks and flows are denominated in the national money of account. In previous weeks we examined the definitions of stocks and flows, as well as the relations between the two. (It might be helpful if you quickly review the previous discussion on stocks and flows, and the relation between the two: flows accumulate to stocks.) Financial stocks and financial flows are denominated in the national money of account. In this blog we will go through the details of keeping track of stocks and flows in the money of account. That will also lead us into a discussion of the relation between “money” and “spending”—how do we “pay for” things?
As discussed in the past two weeks, the money of account is almost always the domestic currency—the money of account chosen by the government. In some cases, however, the accounts can be kept in a foreign currency. For the purposes of this blog we will ignore that complication—all the record keeping discussed here will be presumed to take place in a single national unit of account. Let us begin with the case of an employee earning wages.
While working, the employee earns a flow of wages denominated in a money of account accumulating a monetary claim on the employer. On payday, the employer eliminates the obligation by providing a paycheck that is a liability of the employer’s bank. Again, that is denominated in the national money of account.
If desired, the worker can cash the check at her bank, receiving the government’s currency—again an IOU, but this time a debt of the government. Alternatively, the check can be deposited in the worker’s bank, leaving the worker with an IOU of her bank, denominated in the money of account.
Wage income that is not used for consumption purchases represents a flow of saving, accumulated as a stock of wealth. The saving can be held as a bank deposit, that is, as financial wealth (the bank’s liability).
When it comes time to pay taxes, the worker writes a check to the treasury, which then debits the reserves of the worker’s bank. Reserves are just a special form of government currency used by banks to make payments to one another and to the government. Like all currency, reserves are the government’s IOU.
So, when taxes are paid, the taxpayer’s tax liability to the government is eliminated. At the same time, the government’s IOU that takes the form of bank reserves is also eliminated. The tax payment reduces the worker’s financial wealth because her bank deposit is debited by the amount of the tax payment.
We can conceive of a flow of taxes imposed on workers, for example, as an obligation to pay ten percent of hourly wages to government. A liability to government accumulates over the weeks as wages are earned, which is a claim on the worker’s wealth. The tax liability, measured in the money of account, is eliminated when taxes are paid by reducing the worker’s financial wealth (debiting deposits also measured in the money of account) and the bank’s reserves are simultaneously debited by government.
At the same time, the government’s asset (the tax liability owed by the worker) is eliminated when taxes are paid, and the government’s liability (the reserves held by private banks) is also eliminated.
Sometimes it is useful to compare these flows to water flowing in a river, that gets accumulated as a stock behind a dam. However, it is important to understand that these monetary stocks and flows are conceptually nothing more than accounting entries, measured in the money of account. Unlike water flowing in a stream, or held in a reservoir behind a dam, the money that is flowing or accumulating does not need to have any physical presence beyond ink on paper or electrical charges on a computer hard-drive.
Indeed, in the modern economy, wages can be directly credited to a bank account, and taxes can be paid without use of checks by debiting accounts directly. We can easily imagine doing away with coins and paper notes as well as check books, with all payments made through electronic entries on computer hard-drives.
All financial wealth could similarly be accounted for without use of paper. Indeed, most payments and most financial wealth are already nothing more than electronic entries, always denominated in a national money of account. A payment leads to an electronic debit of the account of the payer, and a credit to the account of the payee—all recorded using electrical charges.
The financial system as electronic scoreboard. The modern financial system is nothing but an elaborate system of record-keeping, a sort of financial scoring of the game of life in a capitalist economy.
For those who are familiar with the sport of American football, financial scoring can be compared with the sport’s scoreboard. When a team scores a touchdown, the official scorer awards points, and electronic pulses are sent to the appropriate combination of LEDs so that the scoreboard will show the number six. As the game progresses, point totals are adjusted for each team.
The points have no real physical presence, they simply reflect a record of the performance of each team according to the rules of the game. They are not “backed” by anything, although they are valuable because the team that accumulates the most points is deemed the “winner”—perhaps rewarded with fame and fortune.
Further, sometimes points are taken away after review by officials determines that rules were broken and that penalties should be assessed. The points that are taken away don’t really go anywhere—they simply disappear as the scorekeeper deducts them from the score.
Similarly, in the game of life, earned income leads to “points” credited to the “score” that is kept by financial institutions. Unlike the game of football, in the game of life, every “point” that is awarded to one player is deducted from the “score” of another—either reducing the payer’s assets or increasing her liabilities.
Accountants in the game of life are very careful to ensure that financial accounts always balance. The payment of wages leads to a debit of the employer’s “score” at the bank, and a credit to the employee’s “score”, but at the same time, the wage payment eliminates the employer’s implicit obligation to pay accrued wages as well as the employee’s legal claim to wages.
So, while the game of life is a bit more complicated than the football game, the idea that record keeping in terms of money is a lot like record keeping in terms of points can help us to remember that money is not a “thing” but rather is a unit of account in which we keep track of all the debits and credits—or, “points”.
Your homework assignment (should you choose to accept it): Think about government spending and taxing in terms of those scoreboard electronic entries. When government “spends money”, where does it come from? When we pay taxes, where does the “money” go? In what sense does the government “spend the money it receives in tax payments?”