How financial systems work: evidence from financial accounts (History of Funds Flow accounts..)

December 1, 2017

Bank of Italy is conducting a conference by the same title.

Here is the speech/opening remarks by  Luigi Federico Signorini, Deputy Governor of the central bank. He points to this interesting history of development of financial accounts, how central banks warmed up to these accounts, the decline of them in research and again their importance post-2008 crisis:

Financial accounts have a long history and we take some pride in having worked on them almost from the beginning. As many in this room will know, the first model accounts were developed by Morris A. Copeland for the US.

The picture above, which has a nice vintage feel to it, summarises his idea of the economy as a money circuit, showing the connections between the institutional sectors. In 1955 the Federal Reserve published its first version of the annual flow of funds. Italy’s first financial accounts appeared about ten years later, in the Annual Report of the Banca d’Italia for the year 1964. We were among the first countries for which financial accounts became available. Of course, the pioneering work at the Fed was an inspiration, but there had been some significant preparatory work here as well. Since the 1940s Paolo Baffi, who was to become Governor many years later (1975-79), had been working on reconstructing the financial statements of the institutional sectors. He was influenced by Giorgio Mortara, an eminent statistician and his teacher, and by Wesley Mitchell, whose work on business cycles he had translated.

There was a golden age of financial accounts between the 1960s and the early 1970s. James Tobin, among others, used them to look at the way agents allocate wealth across financial and non-financial assets; in his Nobel Memorial Lecture in 1981, he discussed ‘Money and finance in the macro-economic process’ using flow-of-fund tables. Tobin and others had built models based on the interaction between the real and the financial sectors. This idea was taken up by central banks. For instance, the 1986 version of the Bank of Italy Quarterly Econometric Model contained a complete description of the links between saving, non-financial investments and financial flows. Financial accounts were also a rather popular subject for research. Surveys of the literature list around 250 works on flows of funds published in twenty years or so after Copeland’s book.

Interest in financial accounts declined in the 1980s, only to pick up again after the crisis. Many factors were at play: a growing focus on the micro foundations of macroeconomics; an increasing concentration on inflation as a target, and on money and credit aggregates as instruments, for monetary policy; some neglect of interconnections across the financial system; and much trust (too much, one would say in retrospect) in the self-correcting mechanism of price adjustments, which implied less interest in the quantities (flows and stocks) that make up financial accounts. On the statistical front, the main effort then was directed at fuller international harmonisation of real statistics, which resulted in the 1993 System of National Accounts; at the same time, as I mentioned earlier, integrating real and financial accounts was proving elusive. 

Financial accounts continued to be used, though to a lesser extent, by economists such as Wynne Godley and Raymond Goldsmith.6
Then the Asian crisis of the late 1990s showed the importance of sectoral financial connections and the need to study the balance sheets of banks, firms, and households. Since the start of monetary union, the ECB’s monetary analytical framework has included financial accounts as a tool for cross-checking its ‘first pillar’ (economic analysis) against its ‘second pillar’ (monetary analysis).8

However, it was the global financial crisis that generated renewed interest. A lesson of the crisis was that tracking sectoral imbalances was important; that an excessive level of debt may cause vulnerabilities; and that therefore the pursuit of financial stability required monitoring the level of corporate and household debt and the leverage of financial institutions. Finance was no longer a mere veil.

Superb stuff..There are quite a few references which should be a great read as well.

Accounts are perhaps the only thing that matters in finance and is also central to understanding economics. But accounting is least appreciated. So much so there is a hierarchy with PhDs in finance seen as superior to PhDs in accounting.


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