Models vs. Accounting

I concluded a very enjoyable exchange with Nick Rowe from Worthwhile Canadian Initiative. You can check it out here. The crux of the discussion was the failure of monetary policy: we're at ZIRP and yet the economy keeps getting worse. How can we reduce interest rates below zero? What is the mechanism by which interest rates impact the real economy, and what is going wrong with that mechanism, &c.?

This mechanism does not exist, but that did not stop Nick from coming up with this--this!--to explain the framing (or "social construction") of monetarism:

Phillips Curve: p = 0.25(y-y*) + 0.5p(t-1) + 0.5E(p)

IS curve: y-y* = n-r

p = 0.25(n-r) + 0.5p(t-1) + 0.5E(p)

B=1/(1+i)

R=P(1+E(p))/(1+r)

(1+i)=(1+r)(1+E(p))

1. P=1 (or p=0 and E(p)=0).

2. B=1/(1-n) (or i=n)

3. R=1/(1-n) (or r=n)

&c

I ask a very simple question: if the private sector wants to increase its net financial assets, can that be achieved by interest rates or can that only be done via fiscal policy (aka deficit spending)? The point of that question was for Nick to realize what monetary policy can and cannot do, and then we could begin a discussion of what cause of this current crises: ie. is the private sector overly leveraged? This is all d'uh stuff to me, and to most people I think, but d'uh never got you a PhD in Economics. Anyway, this is what Nick came back with:

Yep. In a closed economy:

S-I = G-T

That's just an accounting identity. It's a way of using words in a consistent way; it doesn't tell us how the world works.

Isn't that just fantastic?! Someone who spewed "p = 0.25(y-y*) + 0.5p(t-1) + 0.5E(p); IS curve: y-y* = n-r; p = 0.25(n-r) + 0.5p(t-1) + 0.5E(p); B=1/(1+i); R=P(1+E(p))/(1+r); (1+i)=(1+r)(1+E(p))" dismissing accounting because "it's a way of using words in a consistent way; it doesn't tell us how the world works"?! I want everyone to be totally clear on this point -- someone who is trying to understand finance is dismissing accounting. Finance is accounting. If you cannot track the accounting consequences of a financial act, then there was no financial act. I particularly love all the coefficients in Nick's model, 0.25, 0.5, 0.5 etc. Is he sure they are not 0.26, 0.49, and 0.51? Inquiring minds want to see the regressions.

I am more sympathetic towards economic models, and more suspicious towards accounting than most -- I learned both at U Chicago. But the disdain that economists hold accounting in, and the inability to see beyond their models blinds them to understanding the world around them. Dismissing accounting with "It's a way of using words in a consistent way; it doesn't tell us how the world works" by someone who models shows profound... primitiveness. Not sure if there's a better word.

Also, Nick got the pop quiz wrong:

If desired savings increases (i.e. desired consumption falls), then the rate of interest falls until desired savings falls back to where it started (or desired investment increases, or some mixture of the two).

Wrong! Lower interest makes it even more difficult to reach the desired savings level, so lower rates make things better, not worse. Moreover it is impossible to increase net assets within a sector, the solution can only lie out of the sector.