Logic, Theory, and Accounting
One of the mysteries of the universe is that it is logical. Whether in geometry, in physics, or in economics, purely logical theories explain the messy world. It is true that some theories are contradicted by empirical evidence, which suggests that they are not applied to the right problem, or that their assumptions have not been chosen wisely. Yet, some logical theories that seem at first inapplicable to the real world often end up finding applications; I understand that quantum physics provides numerous examples.
It is however as sure as anything can be that an illogical theory is false and useless. One illustration is what I called a logical prank in the protectionists’ trade-deficit fixation. In an article of the Fall issue of Regulation, I wrote:
The logical prank comes from begging the question, what is the problem with a trade deficit? It reveals unfair trade practices, answer protectionists. But how does a protectionist determine that trade is unfair? By observing that it results in a trade deficit. The evidence of a trade deficit and of unfair trade is self-referential.
A smaller mystery in the world is how accounting identities, which are logically true by definition, can be useful. The answer, I think, is that something adjusts in the real world to make the identity always true, and that this thing adjusts by definition of the thing. The identity called the “basic accounting equation” states that assets are equal to liabilities plus shareholder value: A=L+E (the two sides of a balance sheet are equal). This is always true because shareholder value is defined as the difference between assets and liabilities. Profit (or loss) is the residual that provides for the real-world adjustment.
When I was in graduate school, I read something to the effect that accounting is like religion: it always has an answer. I think the author was Kenneth Boulding, but I have never been able to find the quote. (I will send a copy of my latest book to the first one who finds the actual quote. Fine print: I will be the only judge of whether it’s the quote I am looking for!) I am not claiming that religion or accounting are useless.
Matters get complicated in national accounting, perhaps because of what motivated the creation and form of the national accounts (for a glance, see my “What You Always Wanted to Know about GDP But Were Afraid to Ask,” Regulation, Winter 2016-2017, pp. 64-69). In that field, many are tempted to consider an accounting identity as a logical theory that explains the real world without the need for empirical testing or good assumptions. It is true by definition! But national accounting identities, like accounting identities in general, should not be mistaken for theory.
The summit of accounting abuse must be to read an accounting identity incorrectly and then compound the error by deriving a theory from this faulty reading. As I explained before (including in my recent EconLog post “The St. Louis Fed on Imports and GDP,” September 6, 2018), such is precisely the error committed by those who use the national accounts identity GDP = C+I+G+X-M to conclude that imports (M) reduce GDP. In my Regulation article, I repeat this argument and use a brilliant analogy devised by Thomas Firey, the managing editor of Regulation and an occasional blogger on EconLog. My rendition of the analogy:
Think about the guy on the scales who subtracts 1 lb. to factor in the weight of his shoes; his weight doesn’t change if instead he subtracts 2 pounds because on that day he is wearing heavier shoes. Likewise, American output doesn’t change because more imports are both added and subtracted.