The Incorrect Hydraulic Model for Flow of Funds
Explaining Flow of Funds
The Incorrect 'Hydraulic Model' of Flows
The term 'flow of funds' seems to imply that funds are'flowing' in the economy through channels, like water.
This analogy is sometimes referred to as a 'hydraulic model' of economic activity.
The animation shows imaginary money 'flows' in a sector that is selling corporate bonds, buying corporate equities, and then reselling the equities.
The 'Hydraulic Model' is misleading and wrong for several reasons:
- There is an implication that 'money', like water, is pushing its way through the economy, generating a kind of 'hydraulic money pressure' that can move prices up and down.
- The 'flow' analogy seems to suggests that 'money' is 'moving' and that it moves in only one direction.
- The model implies that there is a delay as 'money' moves from station to station in the cycle. There is 'float' in financial markets, but this appears in miscellaneous asset and liability accounts of banks and brokers. In a steady market, the increment in this 'float' would approach zero in flow of funds accounting.
- Money is fungible. Net proceeds from the sale of one asset do not 'flow' to a single alternative asset, but instead to multiple uses, including reduction in debt, current expenses, and investment in many other asset categories.
The 'Flows' Misnomer
The flow of funds tables do not really show 'flows'.
Money is not 'flowing' at all.
The Federal Reserve tables do not show how much money moves or 'flows' from sector A to sector B per quarter or per year.
The circular flow in the diagram, showing a sector that is selling bonds and buying stocks, would be reversed for the counterparty sector that sells stocks and buys bonds.
This would means that a complete 'hydraulic' diagram including both buying and selling sectors would need to show 'money' flowing in both directions at the same time.
The imaginary 'hydraulic pressure' from the 'money flows' would therefore cancel out.
Prices are not driven by 'hydraulic pressure' of money flows, but rather by motivation of buyers and sellers, as stated in the Motivation Axiom.
It is important to understand why the 'hydraulic model' is incorrect, because analysts easily are trapped by faulty reasoning, assuming that 'money flows' exert pressure on prices.
For example:
Over the last generation, U.S. households have been net sellers of corporate equities. A careless analyst might conclude that 'money flowing out of stocks' would drag stock prices downwards. However, this did not happen. For the last twenty years of the 20th century, U.S. equity prices trended upwards.
Despite the unfortunate naming of the 'flow of funds accounts' , the hydraulic model is not appropriate for Capital Flow Analysis.
Before proceeding, check your progress:
Self-Test
For purposes of Capital Flow Analysis, the 'Hydraulic Model' is misleading because:
|
|
The National Flow of Funds Accounts are:
|
|
'Money flowing out of stocks' will:
|
