Accounting identities reveal nothing about causation.
Accounting identities are simply stating that certain variables must balance.
But the identities say nothing about how the variables must balance or the nature of the interaction between them.
Identities are actually definitions of one (or more) of the variables inside them.
Accounting identities cannot reveal causation on their own because of the ceteris paribus problem.
The problem with ceteris paribus is: which things are we keeping constant?
To know which things to keep constant, you have to have some sort of idea of the causal connections.
So accounting identities get us nowhere.
Example: Current Account
One thing almost all economists agree on is that all countries cannot simultaneously be positive net exporters.
That is, they cannot simultaneously all have Current Account surpluses.
This is analogous to the fact that all debts must sum to zero.
Those who have not studied economics (and even those who have!) are often surprised to learn that standard economic theory suggests that net exports have no impact on job creation.
The reason many people draw the wrong implication comes from an accounting identity:
GDP = C + I + G + (X – M), where (X – M) is net exports.
This identity (or definition) is saying that GDP must equal consumption, investment, government spending, and net exports (exports minus imports).
It looks like bigger net exports will boost GDP.
But that ignores the ceteris paribus problem.
In particular, does GDP remain unchanged or (C+I+G)?
Consumption, investment, and government spending are all impacted by net exports, and vice versa.
What if something else is forcing GDP to be constant? What are the underlying causal connections?
The same problem arises when you use another accounting identity:
I = Sp + (T – G) + (M – X)
This identity is saying that money for investment comes from private, government, and foreign savings.
If you ignore the ceteris paribus problem, then it looks like positive net exports (M – X < 0) reduces investment dollar for dollar.
Example: Fisher Equation
Nominal interest = Real interest + Inflation
This identity is actually a definition of real interest.
It looks like an increase in the (nominal) interest rate by the central bank will cause inflation to rise.
Many prominent economists and central bankers have made this mistake, and it has even affected monetary policy decisions.
In reality, there is an ambiguous relationship between nominal interest rates and inflation.
Because the real interest rate is determined by both the supply and demand for credit (the liquidity and Fisher effects) which are not captured in this identity.
As always, never reason from a price change.
Quotes:
“Like all economists, I may use identities as part of my argument. For instance, if I were to argue that rapid growth in the money supply would increase inflation, and that this would increase nominal interest rates, and that this would increase velocity, I might then go on to discuss the impact on NGDP. In that case I’d be using the MV=PY identity as part of my discussion, but I’d also be making causal arguments based on economic theory. I never rely solely on identities to make a causal claim.”
— Scott Sumner
Thanks for reading. Tell your friends.