Balance Sheets and Economics

Balance sheets are an excellent model for helping to understand the state of the economy. Each person and each corporation (I'll use the term entity to refer to either) has one. It records the assets and liabilities of the entity:

The net worth of an incorporated firm (limited liability company) is owed to its owners (shareholders)(*). The net worth of a government is owed to the people whom it governs; when (as is typical) it is negative, it is the national debt, and represents the amount which still must be taxed in order to pay for government spending which has already occurred.

(*) The net worth of an incorporated firm is also known as shareholder equity. Since it is owed to the shareholders, it could be considered to be a liability like any other, but accountants exclude it when referring to the firm's net worth. This is probably because if shareholder equity were treated as other liabilities, net worth would not be a very useful concept – it would generally be zero. (It could still be negative – if the firm's assets were less than its liabilities excluding shareholder equity. This is a very bad situation, in which some of its creditors will not be paid what they are owed, because there is not enough wealth with which to pay them.)

Balance Sheet Mathematics

For every debt in existence, it appears in two balance sheets: the creditor's (i.e. the one it is owed to) as an asset, and the debtor's (i.e. the one who owes it) as a liability(*). (Complex situations involving multiple parties can be treated as a collection of smaller debts, each between two parties).

The monetary values of the creditor's asset and the debtor's liability should be equal. In the case of a monetary debt, a certain amount of money will be transferred in future, and the amount given will obviously exactly equal the amount received. In the case of a non-monetary debt (e.g. the loan of a car), the amount which would be obtained if it were sold is not dependent on the ownership(**). In either case, it is possible that the debtor and creditor produce different estimates, but this simply reflects the accuracy of their estimates, not anything about the underlying reality of the worth of what is owed.

Balance sheets of multiple entities can be aggregated to assess the wealth of the group as a whole, and this can be done very simply. It is best to think of this involving two stages. First, the assets of all the individual balance sheets are aggregated, and similarly the liabilities of all the individual balance sheets are aggregated. Secondly, any debts between the entities are removed from both the assets and the liabilities sides of the aggregate balance sheet.

Absolutely any set of entities can be aggregated in this way. For example, the set of all net debtors, the set of all net creditors, the set of all banks, the set of all firms, the set of all households, the set of all people and cheesemaking firms whose name begins with 'C', every entity in a country, every entity in the world, etc.

Since all the debts between aggregated entities are cancelled out, then (unless there is inter-planetary debt) the net worth of the whole world is simply the set of all things owned by any entity.

(*) While this sounds similar to double-entry book-keeping, it is in fact entirely unrelated. Double-entry book-keeping shows each transaction as a debit in one account and a credit in another account – but both accounts relate to the same entity. The appearance of a debt as an asset and a liability in two different balance sheets refers to two different entities, and is a more fundamental relationship. When one entity owes or is owed something, there is always another entity which is owed or owes the same debt respectively, irrespective of what type of book-keeping (if any) the two entities use.

(**) In some unusual cases, something may be considered to be worth more or less depending on who owns it. For example, people may not be prepared to pay as much for a car previously owned by someone with a reputation for driving badly than one owned by an average person. Or people may pay more for a pen previously owned by a famous actor. However, those situations can be treated as if the creditor has damaged or improved the item after the debt has been paid.

An example

Joe is a self-employed carpenter. Consider the effects of events from his daily life on his balance sheet.

  1. First thing in the morning, Joe goes to a timber merchant to buy some wood. He pays £20 for the wood he needs. The cash he owns (an asset) has reduced by £20. However, he now owns some wood (an asset, worth £20) which he did not have before. Joe's net worth is unchanged.
  2. Joe proceeds to makes a table from the wood. The wood cost him £20, but he can usually sell a table for £100. When he has finished, Joe no longer has the wood (assets have decreased by £20), but he now has a table which he did not have before (assets have increased by £100). Overall, his assets have increased by £80, and his liabilities are unaffected. Therefore Joe's net worth has increased by £80.
  3. For lunch, Joe makes and eats a ham sandwich, with ingredients which he bought the week before. The ham cost him £1.70; the loaf cost £1 for 20 slices, of which he uses 2 (worth £0.10); and the butter cost £2 for 250g, of which he uses 25g (worth £0.20). He no longer owns the bread, butter and ham which he previously owned (assets have decreased by (£1.70 + £0.10 + £0.20) = £2.00). His liabilities are unaffected. Joe's net worth has decreased by £2.00.
  4. Joe sells his table in the afternoon. As expected he sells it for £100. He has £100 cash more than he had before (assets have increased by £100), but he no longer has the table (assets have decreased by £100). As a result of selling the table, Joe's net worth is unchanged.
  5. Joe deposits the £100 in the bank. He no longer has the £100 of cash (assets have reduced by £100). However, he now has an extra £100 bank deposit - a promise from the bank to repay him when he asks for it i.e. the bank owes him £100 (assets have increased by £100). His net worth is unchanged.

Over the day, Joe's net worth has increased by £78 (+ 0 + 80 - 2 + 0 + 0). Does that mean someone else is £78 worse off? We can find out by aggregating the balance sheets of everyone in the world except Joe, and looking at how the net worth changes over the day as a result of Joe's actions.

  1. Assets decrease by £20 (wood), but increase by £20 (cash). Liabilities are unchanged. Net worth is unchanged.
  2. Assets and liabilities are unaffected. Net worth is unchanged.
  3. Assets and liabilities are unaffected. Net worth is unchanged.
  4. Assets increase by £100 (table), but decrease by £100 (cash). Liabilities are unchanged. Net worth is unchanged.
  5. Assets increase by £100 (cash), but liabilities also increase by £100 (the bank owes £100 to Joe). Net worth is unchanged.

So, as a result of Joe's actions, he is £78 richer, and nobody else is any poorer. By including Joe in the aggregation of balance sheets, we can see that the net worth of the world is £78 higher.

How did this happen? It was because Joe created wealth, by combining his labour, his tools and his skill to turn some unformed wood into a table, which makes it more useful and more valuable. The wealth which he created (the table) was greater than his consumption (the plain wood and the ham sandwich) in that time.

Profit - a dirty word?

Russell Brand, the actor and comedian who has become active in politics, said:

The very concept of profit should be hugely reduced. David Cameron [the British Prime Minister] says profit isn't a dirty word. I say profit is a filthy word, because wherever there is profit there is also deficit [...]

If by this, Russell Brand meant that it is not possible for one person to become wealthier without someone else becoming worse off, I believe that the above scenario with Joe the carpenter demonstrates otherwise. I admire Russell Brand's desire to campaign against injustice, but I believe he has fallen into a common fallacy, namely that there is a fixed amount of wealth and that if one person has more, there is less for everyone else.

As implied above, wealth is constantly being created and destroyed. Simply being alive requires a certain level of destruction of wealth (e.g. in consuming food), and manufacturing typically involves the destruction of the raw materials – at least in the sense that they are not in a state ready for use in the manufacturing process. Profit can be seen simply as creating wealth at a faster rate than it is destroyed, and in that sense, profit is essential. Without profit, or at least a precarious break-even, any previously saved stocks of wealth are consumed until there is nothing left, and the entity (or group of entities) is then forced to reduce their consumption immediately to no more than their level of production. This situation is likely to be difficult for an individual e.g. someone who has lost a job and cannot find another, but at least there may be other people who can be counted on to help out for a while. However, when a whole society is consuming more than it produces, and then runs out of stocks, the result may be catastrophic, since there may be nobody who can be called on to help, and there may be conflict over how the limited resources remaining are to be allocated. Needless to say, this situation is best avoided.