There is something the entire SFC modelling community knows it needs to do – but it is hard and not yet done meaningfully to my knowledge.
That is to model insolvency and bankruptcy.
Its hard because for sake of simplicity models are simply aggregates of the whole firm sector – not quite as bad as a single ‘representative firm’ but not far off.
Seemingly modelling interactions between firms involves modelling of agents and network effects between agents – this, with the aid in advances in Graph Theory is a fecund area of study- but it adds a whole extra tier of complexity to models. Is there a way to cut through this and capture the impacts of liquidation at a higher degree of aggregation?
This is important because it appears that the key difference between a ‘normal’ (if their is such a thing) recession and a balance sheet recession is the degree of insolvency caused by the inability to repay debt. In a normal recession profits are depressed but proportionately few firms or individuals go bankrupt, most balance sheets remains in the black, and the economy quickly bounces back. In a balance sheet recession on the other hand as one firm goes bankrupt it creates bills that remain unpaid in other firms, potentially triggering a wave of bankruptcies and unemployment and a ‘death spiral’ fall in effective demand.
The classic treatments of this are of course Fisher, Minsky and Hoyt.
The Krugmanesque concept that creditors=debtors=so what is deflated because (and there are many other reasons) bankrupt firms by definition cant pay their debts.
There is a clue from accountancy as to how to treat valuation of insolvent firms as opposed to solvent firms which I think can cut through this complexity and enable simple aggregate modelling. So far it is just a hunch but I thought I would share it as it is closely related to the thinking I have presented here on the solution to the ‘profits puzzle’.
First some definitions.
Insolvency is not the same as Bankruptcy.
Insolvency is the inability of a firm to pay its liabilities (the Wikipedia definition of inability to pay debts I think is imprecise).
Bankruptcy is the juridical recognition of insolvency. As in most jurisdictions it is illegal for most firms to trade whilst insolvent so unless false accounting is involved (which it often is) then bankruptcy will quickly follow.
The matter is complicated because their are stock and flow aspects to insolvency.
A firm is flow insolvent when its cash flow of revenues plus any reserves of equity/retained profits which provide working capital is insufficient to cover its liabilities (all debts including mercantile credit) and reserves of equity which provide working capital to the firm.
A firm is stock insolvent when its liabilities are not covered by its assets + equity.
Both of the above can be expressed precisely using the fundamental equation of accounting.
I refer to liabilities rather than debts to refer as well as bank credit (which create money) mercantile credit (and almost all commercial transactions of any scale are invoiced). Bank credit is endogenous creation of money, mercantile credit is the increased turnover of existing money (what classically was called fully covered credit) through maturity transformation between firms with strong cash flows and those without. This has become more complicated in recent years in that firms themselves are now issuing financial products which for all intents and purposes is endogenous money creation; though these products are not always fully liquid. But none the less the broad distinction between bank credit and fully covered credit (or Robinson Crusoe type savings if you are of Austrian persuasion) remains.
The fact that both stock and flow insolvency are covered by the same term is confusing. Increasingly legal systems have come to recognise that firms can be restructured by selling assets and cutting costs and still remain as going concerns with positive future cash-flow. Hence in America with have chapter 7 bankruptcy and scholars sometimes refer to the ‘end of bankruptcy’, by which they mean that flow insolvency alone is not sufficient to force closure of a firm unless the firm falls prey to an asset stripper.
The language of central banking has also evolved. We often hear that ‘banks face a crisis of solvency and not liquidity’ by which they mean that banks are stock insolvent not just flow insolvent and that an addition of equity is required.
Ok lets model this using the fundamental accounting equation
(1) Assets-Liabilities =Owners Equity, or in shorthand A-L=OE
We may represent stock insolvency, or better viability insolvency as we may better term it by the following inequality:
Whereas flow insolvency, or perhaps better liquidity insolvency can be defined as follows
The valuation of a firm that is bankrupt is quite different from that of one that is a going concern and that I think is the key.
The valuation of a firm as a going concerns involves addition of the value of goodwill. The valuation of a firm for break up purposes cannot include goodwill because there will no firm going forward. As we have blogged before the correct treatment of goodwill is critical to understanding the ‘profits puzzle’ of economics. If a firm is exclusively making profits from assets which are alienable (salable) then it might as well be bankrupt because these same assets can be rented by anyone else- which are simple transfer payments between segments of the economy. If a firm is to generate growth it has to generate value in the firms equity value over and above the firms asset value – goodwill – the franchise value of the firm. This valuation like that of any other factor (and the solution is to treat equity in franchise value as a factor) will have a factor return, and opportunity cost to keep that factor in production (which in cash terms is imply the average rate of profit in the economy) and a rental factor dependent on the scarcity value that the firm creates – or put another way the degree of oligopoly in the market or markets the firms operates. We showed in our previous post that the factor income due to equity ownership of franchise value is equal to Total Factor Productivity or the Solow Residual, its that simple.
So economic growth is equivalent to the creation of franchise value by firms, recession is equivalent to its destruction. This concept goes beyond the crude concept of ‘capital destruction’ as it avoids capital theory fallacies by carefully separating out factor returns and rents from all factors including fixed capital land rents, money rents (interest) and equity in franchise value.
So when a firm goes bankrupt its future goodwill generating capacity is zero and the firms value is solely that of alienable tangible assets.
Or put more formally:
For a solvent firm its valuation is. This is of course simplistic and assume that the owners equity portion is clearly identifiable and attracts a market price, and that similarly future cash flows and liabilities of a firm can be forecast (which does not mean that they can be forecast accurately).
If a firm is profitable it attracts a positive valuation, if not viable equity must be written off, assets sold and the asset owners matched to the liabilities must take a haircut.
As with our profits formula we can split a positive valuation into two. That resulting from its ownership of alienable assets and once from the franchise value of its equity (goodwill). As follows
(5) Going Concern Valuation=discounted cash flow stream of Franchise value+Asset Value-Liabilities
(6) Break Up Valuation =discounted cash flow stream of Asset Value-Liabilities
Subtracting 5 from 6 we have
(7) Rate of change of negative growth from bankruptcy =ΔGoodwill
So in aggregate terms ‘all’ we need to do to model the impact of bankruptcy is add a factor for goodwill aggregated in the economy as a whole.
Now you might say that this is by definition true as an accounting identity and hardly worth saying. But the lesson of the whole post-Keynesian project is that things are never too obvious not to state.
Modelling the rate of change of goodwill is easier said than done. It requires I believe a reproduction model of different sectors of the economy (rent seeking and productive) and an accurate breakdown of cashflows for each of the five factors. But, and this is the key, it can be done without the full complexities of agent based modelling. This may require an probability density function for firms of different levels of profit (and hence equity valuations) and an algorithmic to value firms differently with negative (viability insolvency) balance sheets, but it is possible and critically may be possible with most off the shelf SFC modelling packages.