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The Financial Management
Business vs. Governmentt

Financial Management of a Typical Business

The primary tool used in managing the financials of a business is the Earnings Statement.  This is a summary of the business Revenue and Expenses, the difference (Revenue minus Expenses) being the business Earnings (or Net Profit).  The Revenue and Expense accounts are typically divided into categories relevant to the particular business that the business manager may wish to monitor.  For example, the manager may decide to divide Revenue separately into sales of products and services, with each of those further sub-divided into sales of specific products and services.  Expenses may be divided into direct expenses (such as cost-of-goods-sold, and that sub-divided further into, eg., payroll, product inventory, materials, etc.) and indirect (or overhead) expenses, such as rent, utilities, shipping, taxes, etc.

A business also has a Balance Sheet.  Whereas the Earning Statement measures the flow of money through the business, the Balance Sheet measures its wealth in Asset and Liability accounts, the difference (Assets minus Liabilities) being the business Equity (or Net Worth).  The Asset accounts show the present value of what the business owns (eg., cash-in-bank, land-buildings, machinery-equipment, financial investments, etc.), and the Liability accounts show the present value of what it owes (eg., accrued-payroll, vendors-payable, loans-payable, etc.). 

Business managers closely monitor the Net Profit in the Earnings Statement to verify that it's staying generally where expected — and when it deviates from expectation, the manager drills down through the Revenue and Expense accounts to determine the cause of the deviation (eg., a supply cost increase, a product sales decrease, etc.) to assess options for correcting it (eg., changing suppliers, increasing advertising, etc.).  The Equity account in the Balance Sheet is monitored less often — it's more a measure of the safety margin (or available growth opportunity) for the business.

Financial Management of our National Government

Contrast this with the financial management of our (USA) national government.  For an organization much larger than our largest business, we're trying to manage it via control of a single number - the interest the Fed pays banks on their excess reserves!  And when and how to change that number is based on insights gleaned from mathematical models derived by philosophers (aka, economists)!  Is it any wonder we have booms and busts and periodic crises?!

Our national government has an Earnings Statement, called the National Income and Product Accounts (NIPA) maintained by the Bureau of Economic Analysis (BEA).  Wikipedia has an easily-readable description of these accounts — but for those with a reasonable understanding of business accounting, the BEA's NIPA Handbook provides a much more complete and accurate description of them.  The Expense side of the Earnings statement is called the Gross Domestic Product (GDP) — the Revenue side, the Gross Domestic Income (GDI).

You'll recognize the GDP as the economists' accepted measure of the financial health of the nation's economy — the greater the GDP, the stronger the economy.  But note that the GDP is an accounting of the Expenses (ie., the spending) in the national economy.  The major expense categories of GDP are consumer spending (70% of GDP), business spending (17%), government spending (17%) and foreign (export minus import) spending (-3%) — each of which is further divided into numerous subsidiary accounts.

You'll also note in the national accounting that GDI equals GDP — because all revenue in the national economy (ie., consumer, business, government and foreign income) results from someone else's spending (and vice versa).  Unlike the Business, the national economy has no Earnings (or Net Profit) to deal with.  The national accounts measure the flow of Revenue and Expenses, just like the business, but with no need to ever post Earnings to a Balance Sheet.

So why isn't our national economy managed like a business?  Why isn't a financial manager monitoring the GDP — and when it deviates from expectation, drilling down into the GDP and GDI accounts to determine the cause of the deviation — so as to assess the options for correcting it?  Would not this be a MUCH more rational way to manage the economy?!

BEA looks quite capable of doing that management if authorized — and it could be moved under the central bank if greater freedom from political influence is desired1.  BEA should be given the power to infuence the content and frequency (and automation) of the financial reporting it gets its data from.  That reporting currently abounds in errors, omissions and ambiguities (and its data collection is far under-automated).  It's only BEA's adherence to double-entry and accrual accounting — and the law of large numbers — that makes GDP useful now to the Fed and the economics community.

1 If greater freedom from political influence is desired, I'd like to see the central bank given sole authority over how to pay for new government programs.  We saw in The "No Free Lunch" Myth that any problems resulting from government spending result, not from the spending itself, but from HOW the spending is done.  So let the elected officials specify WHAT is to be done, but let the central bank determine the best means for paying for it, ie., borrowing, taxing and/or creating.  That focuses financial expertise where it's needed without compromising the freedom to do whatever is desired.

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