Monday, February 29, 2016

Accounting Identities are Useful

Nick Rowe directs us today to an eyebrow-raiser. Economist Ankit Mital writes
In the current system of cross-border bookkeeping, unilateral transfers are recorded in the current account (income from trade and foreign business interests) and not the capital account (financial transactions that end up balancing the current account deficit or surplus) side of the transactions.
This is really interesting to those of us who mind our accounting identities. In its simplest form, the balance of payments identity states that the current (CA) and capital account (KA) balances sum to zero. That is, any transaction which increases the CA balance must also decrease the KA balance. If you see the CA balance changing with no corresponding change in the KA balance then you are failing to correctly record the transaction.

So what is Mital missing? First, the KA balance is defined to be the change in foreign ownership of domestic assets less the change in domestic ownership of foreign assets. So if you— residing in the UK— send me £1, then the UK sees foreign ownership of domestic assets rise. That is, the KA rises by £1– exactly balancing the £1 fall in the CA.

It does not matter exactly how the transfer takes place. If you send me \$1.40 instead, then the UK sees domestic ownership of foreign assets fall by \$1.40, raising the KA by \$1.40 and exactly balancing the \$1.40 fall in the CA. If in my name you hand a £1 coin to a London bank to open a deposit account, then again the UK sees foreign ownership of domestic assets rise. (The relevant asset being the deposit and not the coin which moves only between UK actors.)

And there lies the value in minding accounting identities. They force one to think carefully about what else changes.