Flow of funds analysis: A combination of Roman law, accounting and economics

1.History of the Flow-of-Funds Accounts

Flow of funds analysis began in the 1940s as a branch of national accounting, then known as social accounting,11 which referred to the preparation and interpretation of overall economic statistics in the form of financial statements – that is, in the form of balancing accounts for the economy as a whole that were analogous to the statements prepared for individual business. The flow of funds system is designed to bring the financial activities of an economy into explicit statistical relationship with one another and into direct relation to data on the nonfinancial activities that generate income and production. The purpose of the account is to provide, systematically, the aggregate measures of transactions needed to identify both influences of the nonfinancial economy on financial markets and reciprocal influences of financial market developments on demand for goods and services, sources of amounts of saving and investment, and the structure of income. Reference must be made to the influence of Van Cleeff [2] and Derksen [3], and so of Stone [4] and Aukrust [5]. Mitchell [6] and Copeland’s [7, 8, 9] system of Moneyflows Accounts, widely known as Flow of Funds Accounts today,22 should be mentioned not only for specific ideas but also for their vigorous advocacy of an integrated structure. The system they have developed incorporates not only current productive activity and the distribution and transfer of income, but also those transactions which help finance income, transfer and production flows.

The Moneyflows Accounts conceive of the economy as composed of groups of units that are continuously

making and receiving payments. Mitchel summarizes the framework of the accounts in the following manner:

The statements of the sectors tell who has paid and who has received how much on account of various types of transactions or objects of payment; the part of the statements is referred to as ‘statement of payments’. The statements also show the financial assets owned and liabilities incurred by each sector; the part of the statements is referred to as ‘statement of balances’. Table 1 is the bird’s eye view of the total system of the Moneyflows Accounts, which has been compiled by Shishido [10] from Tables 18--27 and 40 of Copeland [9]. It is remarkable to find that the present-day System of National Accounts (SNA), which is supposed to be based on the product-flow rather than on the funds-flow method after the 1968 revision that has been supervised by Richard Stone, has much resemblance to the Moneyflows Accounts, at least in appearance, than to the income-output-expenditure table33 presented in Meade and Stone [12]. The differences lie only in the accounting principles.

The name ‘flow of funds’ is attributable to Flow of Funds in the United States 1939–1953, which was the first official statistics based on the Mitchell and Copeland’s idea, published by the Board of Governors of the Federal Reserve System (the Fed) in 1955 [13].44 The Bank of England (BOE) was regularly publishing statements named Daily Flow of Funds from the beginning of eighteenth century55 until the 1970s,66 which recorded the ‘flow of funds’ between the BOE and the private sector due to the changes in the outstanding banknotes and deposits, and in the corresponding assets;77 it is said to be the origin of the word.88 The Fed is still publishing the Flow of Funds Accounts today under the name of Financial Accounts even though the scope of the statistics has been narrowed in 1959 so that the present-day statistics no longer include the nonfinancial transactions.99

Developing quarterly Flow of Funds Accounts was the principal activity at the Fed between 1955 and 1959.

As Keynes [19, p. 175] contended, the classical theory of loanable funds regarded “the rate of interest as the factor which brings the demand for investment and the willingness to save into equilibrium with one another”. In the diagram, which Keynes reproduced from the best-selling textbook of neoclassical economics by Carver [20, p. 243], the saving curve is illustrated as upward sloping, and the investment curve is depicted as downward sloping so that the two curves have an intersection1212 (see Fig. 1). Carver [20, p. 246] also mentioned the possibility that the saving curve had a downward rather than upward slope. The idea was first conceived by Cassel [21, p. 144]: “persons desiring to procure for themselves a certain annual income are compelled to accumulate a much larger capital if the rate of interest is low”. In other words, a person who wants to keep his/her consumption level unaltered before and after retirement will increase saving if the interest rate is lowered, so that a downward saving curve might not be unusual. It is a problematic situation because the market alone cannot determine the interest rate especially if the two curves have no intersection as depicted in Fig. 2. In either case, since it was (and still is) practically difficult to empirically depict the saving and investment curves, the Fed was obliged to constantly observe the saving-investment gap and set the Federal Funds Rate so to minimize the gap. The changes of the Flow of Funds Accounts were necessary for the Fed to promptly publish the data of ‘net financial surplus’, which is easily obtainable from balance sheets as the changes in net worth, as a proxy to the saving-investment gap.

Figure 1.

Upward-sloping saving and downward-sloping investment curves.

Figure 2.

Downward-sloping saving and investment curves.

2.Roaring Twenties and the Great Depression

After the drastic changes in the statistics, the present-day Flow-of-Funds Accounts or Financial Accounts as it is known today covers only the lender-borrower relationship that corresponds to financial transactions rather than the more general payer-payee relationship that includes both real and financial transactions. As Taylor [18, p. 104] remarks, “it is these changes, more than that followed, that may have let Copeland feel that moneyflows analysis had been lost somewhere along the way”. To ensure a non-recurrence of the bitter experience of the Great Depression, Mitchell and Copeland urged a better understanding of the circulation of funds, the means of payment, in the macro-economy.

It is well known that the Great Depression was triggered by a stock market crash of 1929, however, what caught their attention was the dramatic contrast between the 1920s and 1930s.1313 Before ending production in 1927, the Ford Motor Company produced more than 15 million automobile christened Ford Model T at low cost by adopting the assembly-line production method making it possible for the common middle-class American family to own a car.1414 Henry Ford also introduced the Fordson Model F, a wildly popular mass-produced tractor, spreading the productivity revolution in manufacturing into agriculture. The electrically recorded audio disks appeared for the first time in 1925; Western Electric integrated electrical microphones, electronic signal amplifiers and electromechanical recorders into one complete system, which was adopted by major U.S. record labels. Two years later, in 1927, the first commercial talking (and singing) picture Jazz Singer was produced by Warner Brothers1515 synchronizing the sound with film.1616 The Americans who finally found leisure time thanks to the high productivity crowded the movie theaters. The National Broadcasting Company began regular broadcasting with telephone links between New York and other Eastern cities; the Red Network offered commercially sponsored entertainment and music programming; the Blue Network broadcast news and cultural programs with no sponsors.1717

The great inventions and the substantial productivity growth of the Roaring Twenties surely brought a consumption and investment explosion; the corporate profits surged so did the stock and land prices. However, after the Black Tuesday in the fall of 1929, the U.S. economic landscape changed dramatically.1818 The plunge in stock and real estate market rapidly cooled the consumption fever. The manufacturing plants went idle so did the workers. Many families did not have money to buy things, and as a consequence, consumer demand for manufactured goods fell off even further. In the early 1930s, crop prices also dropped so low that many farmers who were in debt as a result of their heavy investment in new machinery went bankrupt and lost their farms as depicted in John Steinbeck’s novels. People found it difficult to understand how such a severe depression could follow a decade of the unprecedented prosperity. Mitchell and Copeland sought the answer in the payer-payee relationship between the institutional sectors; they surmised that funds, the means of payment, are the lifeblood that circulates around the economy.

Since funds, which is the sole currency in the pure credit economy1919 we live today, exist only in the bank’s balance sheets, accounting is a necessity for the virtual currency. Furthermore, the assets and liabilities in the bankers’ accounts mean claims and obligations so that law is another prerequisite for the existence of funds. The present paper is an attempt to detail the historical background of the ‘flow of funds’ analysis, and to clarify the relationship, or rather interdependence, between law, accounting and economics.

Both philosophy and science rely on evidences as well as on logics. The difference between the two is the balance; if you put more emphasis on evidences than on logics, it is called science; if you rely more on logics than on evidences, it is referred to as philosophy. We should remember that the evidences and the logics are interdependent rather than independent. Since evidences are often given in numbers, such as GDP and net worth, insight into the functioning of an economy can be greatly enhanced by casting available information into a systematic and comprehensive structure of economic accounts. Application of accounting discipline to the organization of economic data aids in both collection and interpretation of economic and jurisprudential knowledge, for it highlights gaps in the basic statistics and clarifies interrelations among the parts of the structure. In the next section, we will discuss the origin of the concept of funds in relation to the banker’s accounts of the ancient Rome, from which the quadruple entry bookkeeping, the backbone of the today’s national accounting, stems.

3.Roman law and the ancient bankers2121

The Duodecim Tabulae (Twelve Tables) was a set of laws inscribed on 12 bronze tablets2222 created in the Roman Republic around 450 BCE. The laws relating to economic activities consist of two parts: jus in rem and jus in personam. Jus in rem is the exclusive dominion of a person over res; while res corporales are physical and tangible objects such as furniture, building, and land, res incorporales are intangible abstract things such as writing, music, and method of manufacture. Jus in personam or obligatio to be precise is an explicit agreement between specific parties, in which one party is obliged to do or to perform some specific duties on behalf of the other. For example, the Duodecim Tabulae stipulates that a purchaser of res does not get dominium until full payment is made. The purchaser of res gets possessio at the time of delivery and may be asserted against a third party, but may not be asserted against the vender until the payment is fulfilled. Dominium is the exclusive right to use (usus), to profit from (fructus), and to dispose of (abusus) a particular res.2323Possessio is the right to possession or occupancy; possessio allows the possessor to exclusively use, and to profit from the particular res without impairing the substance of the res,2424 but does not allow disposing of it.2525 The ideas are highly sophisticated; but the trouble was that Rome at that time had no minted coins to make payments. Romans started to produce coins only after 268 BCE. According to Naturalis Historia (Natural History; XXXIV), an early encyclopedia compiled in the first century CE, the Romans probably established an official currency unit, the as or a pound of bronze, at the beginning of the Republic era around 500 BCE. And yet the Lex Papiria Iulia, which is a Roman law of 430 BCE, provides that a fine as a penalty must be paid in aes rude (unworked lumps of bronze) and not in cattle, as hitherto was in use, with the equivalent of a sheep for ten asses and an ox for one hundred asses.2626

As for jus in personam, the Duodecim Tabulae did not solve but rather created problems because the law legalized the old Roman custom of nexum. Nexum was an ancient form of debt bondage contract in which the debtor pledged his/her person as collateral should he/she default on his/her loan or fail to fulfill any obligations.2727 As the name Res Publica (Roman Republic) indicates, anything other than res propria, the res subject to private ownership, were res publicae so that they were subject to communio of the populus Romanus (Roman citizens). Communio is the right, which is shared by two or more people, to use, to profit from, and to dispose of a particular res; each co-owner may use and profit from the entire property in proportion to its share, however, no co-owner may dispose of or make any alteration to the res without the consent of the other co-owners. The idea of communio also applied to land so that, in the early republic era, people could freely graze their livestock in the abundant communa pasture (common pastures). We do not know exactly why but a great majority of the communa pasture was lost within the first two centuries of the establishment of the republic, though, one apparent reason for the loss was to make room for the construction of the Forum Romanum (Roman Forum). Afterall, the Latins were sheep farmers, and semi-nomadic shepherds in their origin; thousands of people lost their livelihood and went into heavy debt. Under the nexum contract, a debtor became a nexus/nexa (bond slave) if he/she failed to pay the debt on or before the promised date; he/she was not freed until the debt is paid off.2828

Lex Poetelia Papiria that was enforced in 326 BCE nullified nexum and introduced a new form of contract known as mutuum; the law forbade holding debtors in bondage for their debt and required instead that the debtor’s property be used as collateral.2929 All people confined under the nexum contract were released, and nexum as a form of legal contract was forbidden thereafter. Mutuum as stipulated in the lex consisted of two pairs of jus in personam: the obligatio and the obligare.3030 The obligatio is a contract in which the first party loans some res to the second party who is allowed to use or to profit from it, and also to consume it or to sell it to another, but is bound to return an equivalent of the original res. The obligare is a contract in which the second party put up another res of equal value as a collateral; if the second party fails to fulfil its obligatio, the first party can seize the collateral or sell it to another to have its own claims paid, but cannot seek out the second party for any further compensation, even if the collateral does not cover the full value of the defaulted amount.3131 Although the debtors generally welcomed the new law, Lex Poetelia Papiria alone did not solve the economic problems because many of the peasants, then known as plebes, had so little to offer as collateral. As a result, the Republic was obliged to absorb the unemployed people, many of them were liberti (freedmen), by promoting new industries, namely trade and commerce. Two brand new systems to create jobs for the people who had no capital endorsement were established: the argentarii (notary bankers) and the auctiones (public auctions).

In its origin, the argentarii, later known as the commercial bankers of Rome, were notaries who were authorized by the Republic to document business transactions.3232 Livy mentions in his well-known history book Ab Urbe Condita Libri (The History of Rome; IX. 40) that the silver shields, which decorated the argentarii’s office,3333 were a part of the distribution of war-booty from the Samnite Wars so that the existence of argentarii at Rome can be proved as early as 311 BCE. One remarkable feature in Rome was that the banking system emerged before the city minted its own coins. It was around 211 BCE when the Romans created a coinage system, usually referred to as the Denarius System;3434 however, a significant amount of coins started to circulate only after the coinage reform of Augustus that took place in 23 BCE.3535 Gaius’ Institutiones (Institutes of Roman Law; IV. 126), written around 161 CE, confirms that the argentarii regularly took part in auctiones, a symbol of the Roman market economy.3636 An auctio was a sort of public auction, either permanent or temporary market, which functioned much more as a present-day wholesale market. It was a praeco (auctioneer) who presided over an auctio and awarded the objects to the highest bidders while it was an argentarius who kept the register of the sales.3737

The nineteenth-century discovery in Pompeii of the tabulae ceratae (wax-covered tablets) of Lucius Caecilius Iucundus, a first-century CE argentarius, represent the most illustrative preserved testimony on the daily operations of the argentarii.3838 According to the archaeological evidences, the argentarii recorded the names of the vendor and the purchaser in addition to the details and the total value of the sold items into the official register known as auctionalis, on which seven witnesses inscribed their names and impressed seals.3939 The argentarii put the auctionales into solid wooden boxes and stored them in a safe place; some of them were stored there for several decades. This practice suggests that the auctionales have doubled as certificates of pledge. The records of sale were also written into the argentarii rationes (banker’s books), namely adversaria and rationes mensae. While an adversaria was a book that recorded all the banking transactions in the order of occurrence, a ratio mensa was a book that recorded each customer’s transactions successively.4040 The argentarius credit the seller’s ratio mensa and debit the adversaria – the bank ledger; the argentarii referred to the book entries as credito. At the same time, the argentarius debit the buyer’s ratio mensa and credit the adversaria; the argentarii referred to it as debito.4141 This practice known as bilancia4242 is considered to be the origin of double entry bookkeeping. Actually, there are four simultaneous entries of the amount of the proceeds; twice in the adversaria and once each in the vender’s and purchaser’s rationes mensae. In the today’s national accounting terminology, the former is known as vertical double entry, and the latter is called horizontal double entry; the combination of the two is referred to as quadruple entry.4343

The credit from auction sales, which was known as uacua pecunia (virtual currency)4444 or more simply as nomina, was transferred between the clients of argentarii as a means of payments; the practice was then called solutio imaginaria (virtual payment). The payment in uacua pecunia was widely accepted as a method of payment during the Republic era.4545Uacua pecunia is considered to be the origin of ‘funds’ as we refer to it today; funds are casually defined as the value deposited at a bank.4646Argentarii also often credited uacua pecunia to their customers’ accounts on the condition that the customers would pay it back on or before an agreed date; this kind of operation was known as creditum. The lenders other than argentarii lend funds in their possession; this practice was referred to as mutuum if collateralized and known casually as pecuniam credere otherwise.4747

4.Concluding remarks

Funds was one of the popular academic topics, both in law and economics, at the turn of the nineteenth and twentieth centuries after the excavation of a boxful of tabulae ceratae at Pompeii in 1875. It was Davenport [47, 48] and Taussig [49]4848 who invented the modern concept of funds in relation to the banking operations as is summarized and illustrated in Tsujimura K and Tsujimura M [17]. Funds are created when a bank credits customer’s account with deposit and the customer incurs loan liability; funds are removed from circulation when the loan is paid off. Alternatively, funds are created when a bank purchases negotiable instruments such as Treasury Securities from its customer, and the funds are eliminated when the instruments are sold back or redeemed;4949 central banks often create funds by purchasing bonds through open market operations. The funds circulate in the economy as a means of payment, which is referred to as transfer of funds in a broad sense; ‘payment’ today is synonymous with ‘transfer of funds’.

It is not widely known, though, the first economist who made a systematic use of ‘flow of funds’ account was Ragnar Frisch [50].5050 He not only invented the concept of open market operation, the indispensable tool for modern central banking,5151 but also demonstrated the effects of the operations with his three-sector five-instrument model. The three sectors, the central bank, commercial (and savings) banks and the non-bank sector, make and receive payments through five instruments: banknotes, reserve deposit, bank deposits, bank loans and the open market operations. The payments between the sectors are summarized in Table 2. While nonbank sector holds its funds as ‘bank deposits’, the commercial banks deposit their funds at the central bank as ‘reserve deposit’. The commercial banks lend their funds to the nonbank sector. In this model, banknotes are assumed to be inconvertible. In such a case, a banknote is merely an order directing the issuing bank to shift a designated amount of funds to bearer’s account. The funds are shifted from the customer’s account to an inscribed deposit pool upon the issuance of a banknote; then the funds are shifted from the deposit pool to the bearer’s account upon presentment. Thus, the funds are shifted from the nonbank sector to the central bank at the issuance, and are paid back to the nonfinancial sector when the notes are returned to the central bank. Nonfinancial transactions are excluded from the table because neither the central bank nor the commercial banks are assumed to engage in nonfinancial transactions.

In the above scenario, the central bank solely supplies the necessary funds through open market operations. Frisch manually calculated the propagation process of the payments through the payer-payee relationship between the sectors to show the effects of the open market operations. More recently the above-mentioned Tsujimura K and Tsujimura M [17] used the matrix algebra proposed by Stone [53] and Klein [54] to apply the Frisch’s model to the U.S. quantitative easing, a countermeasure to the collapse of the subprime mortgage bubble of the noughties. Tsujimuras’ study is not based on the present-day style Flow of Funds Accounts or Financial Accounts,5252instead, they made a pseudo ‘flow of funds’ matrix using the Integrated Macroeconomic Accounts for the United States, which covers both the financial and nonfinancial activities, as source data. The authors sincerely hope that this experiment is the first small step to fulfill the Mitchell and Copeland’s dream – to understand the interactions between the financial and nonfinancial economy so as not to repeat the bitter experience of the 1930s.