There are two wonderful lectures by Marc Lavoie given at the UMKC two years ago. I had seen them that time but forgot to post it on my blog.
Likely you might have seen it, but if not, here they are.
Lecture 1: Essentials of Heterodox And Post-Keynesian Economics
Click picture to view the video on YouTube.
Lecture 2: Workshop on stock-flow consistent modeling
Click picture to view the video on YouTube.
Now Britain finds itself in an alarming new landscape, where our very ways of feeding ourselves, like so much else, look uncertain.
– Bee Wilson, The New Yorker
Paul Krugman has a post The Macroeconomics of Brexit: Motivated Reasoning? on his blog The Conscience Of A Liberal about how “experts” exaggerated claims of the impact of a result to leave in the recent UK EU membership referendum (“Brexit”). Quite agree with Paul Krugman. When Michael Gove told Sky News that people in the UK have had enough of experts, he was laughed at. Video here.
Needless to say this is not an endorsement of Michael Gove’s other political position. Strange times, when you defend someone with different political ideology. The above is just meant to highlight a point that experts exaggerated and that people knew.
John Maynard Keynes also said this in the GT:
But although the doctrine itself has remained unquestioned by orthodox economists up to a late date, its signal failure for purposes of scientific prediction has greatly impaired, in the course of time, the prestige of its practitioners. For professional economists, after Malthus, were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation;— a discrepancy which the ordinary man has not failed to observe, with the result of his growing unwillingness to accord to economists that measure of respect which he gives to other groups of scientists whose theoretical results are confirmed by observation when they are applied to the facts.
Paul Krugman’s main point is that economists’ arguments were motivated reasoning, involved circular reasoning and assumed what they wanted their model to output.
But maybe Paul Krugman himself is doing so? Krugman claims:
I believe that Brexit is a tragic development, which will do substantial long-run economic harm. But what we’re hearing overwhelmingly from economists is the claim that it will also have severe short-run adverse impacts. And that claim seems dubious.
Okay, financial markets have improved after some initial panic caused by the fear of fear. and FTSE 100 is at year-to-day highs. But Krugman still wishes to claim that Brexit is bad long term:
OK, let’s start at the beginning. Brexit will almost certainly have an adverse effect on British trade; even if the UK ends up with a Norway-type agreement with the EU, the loss of guaranteed access to the EU market will affect firms’ decisions about investments, and inhibit trade flows.
This reduction in trade relative to what would otherwise happen will, in turn, make the British economy less productive and poorer than it would otherwise have been. It takes fairly heroic assumptions to make this into a specific number, but 2-3 percent lower income in perpetuity seems plausible.
So far, so good, or rather so bad: this is standard economics, basically Ricardo with a dash of new trade theory.
Firstly it claims that is takes heroic assumptions. Second, but more importantly, Ricardo’s theory? Seriously? Ricardo’s theory and new trade theory claim there is convergence of successful and unsuccessful economies under free trade but emperically what is observed is that because of the process of circular and cumulative causation, there is polarization, not convergence.
It should be possible for the United Kingdom to negotiate protective arrangements (especially in manufactures) in such a way that the EU does not impose punitive tariffs and its exports do not suffer. Trade won’t suffer because although the propensity to import reduces, the government can expand domestic demand since such policies might ease the balance of payments constraint and the volume of UK imports won’t fall.
More generally, the solution of the problems of the world can come about if there is a concerted action, in which fiscal policy is coordinated and there are set of rules for balance-of-payments targets. In this system of regulated trade, world trade can rise because of higher world income as compared to a world with free trade.
Brexit should make economists realize that their models do not conform to empirical data. Ricardo and new trade theory can be cast aside.
Tom Keene and Francine Lacqua of Bloomberg interview Mervyn King post the Brexit vote. What I liked about the interview is that King says explicitly that the UK politicians exaggerated the impact of the leave vote. In another interview to BBC, he said explicitly that the UK Treasury exaggerated. He also criticizes the assumptions people made when putting out the numbers.
click picture to open the video on Bloomberg’s site
When Tom Keene asks him what he says as a “card carrying member of the UK elite” on what people think of common people, Mervyn King says that the UK political class has lost touch with them and has alienated them and were not allowed to discuss certain issues.
This is not a lefty or a socialist saying all this, this is Mervyn King. This goes on to prove that the UK left is clueless about economic impacts of their own ideas. There was hardly any noise against the remain camp.
Even heterodox economists supported remain!
He even says the fall in the pound is not a cause for concern as it can do good for UK trade. Which is a good point. What matters is expectations of the exchange rate more than the exchange rate itself for alarm and now expectations have stabilized.
Of course it does. If banks restrict their lending, it has an effect on aggregate expenditure as producers will postpone their plans and consumers might spend less. If banks increase their animal spirits, and lend more, producers and consumers borrow more with effect on aggregate demand and output.
But is growth only caused by bank lending?
In a recent article on Brexit, Richard Werner says:
I have been trained in international and monetary economics at the London School of Economics and have a doctorate from the University of Oxford in economics. I have studied such issues for several decades. I have also recently tested, using advanced quantitative techniques, the question of the size of impact on GDP from entry to or exit from the EU or the eurozone. The conclusion is that this makes no difference to economic growth, and everyone who claims the opposite is not guided by the facts. The reason is that economic growth and national income are almost entirely determined by a factor that is decided at home, namely the amount of bank credit created for productive purposes.
But this logic is carrying the logic in my first paragraph too much. Causality is a complicated issue. Banks don’t lend without thinking anything about its customer. Werner even claims that he has confirmed it with causality tests. But these tests have their own fallacies such as post hoc ergo propter hoc.
Let’s take a specific example. Suppose, I make a robot which does all household stuff for you, such as cooking food, washing your clothes and ironing them and keeping them back in your wardrobe. Basically any household stuff. Suppose I also make it difficult for anyone to replicate or copy it. My product – the robot – will sell like hot cakes all over the world, if the pricing works out cheap. The sales of my firm will benefit employees and stock holders and it will greatly benefit India, where I reside. Banks will lend me of course but it’s clear that the causality of the rise of output is more my innovation and not bank lending. More generally one can ask other questions: how was I successful in innovating? Perhaps my education was subsidized and I did most of my research was carried out in a university before I corporatized the idea. Or maybe I paid employees a lot which made them productive.
There can be various other reasons, such as a fiscal expansion causing a rise in domestic demand and output, leading banks to lend more when they spot the trend and are confident of their lending. In that case, you could say that fiscal policy caused growth.
Post Brexit, two important things can be identified – which have already been talked about such as by the UK Treasury or NIESR. They are UK trade with the EU and migration. Migration is a complicated subject. If the UK regulates low skill migration, wages can rise and will contribute positively to aggregate demand. Allowing high skill migration to continue can keep UK firms competitive in international markets. Trade tariffs have to be renegotiated with the EU. UK politicians can ignore the message of the referendum result and reduce tariffs or, they can raise tariffs. A lot depends on how the political climate evolves. Just saying growth depends on bank lending implies that these trade and migration policies have no impact, which is completely wrong.
tl;dr summary: causality is a complicated subject.
The commentary after the EU Referendum has moved into a consensus from economists claiming that “Brexit” will make the UK poorer. So we hear it from Paul Krugman:
Yes, Brexit will make Britain poorer
Krugman’s thoughts are also echoed by Simon-Wren Lewis. First SWL claims that:
Calculating the size of this effect is an exercise in trade economics not macroeconomics
I don’t understand this. Calculation is both an exercise in trade economics and macroeconomics. So in stock-flow consistent models of the open economy, you see such a thing. It’s both macroeconomics and trade. Trade is automatically incorporated in a macroeconomic model.
This is not just a minor point in semantics. In stock-flow-consistent models, one cannot avoid some parts and talk of the rest. One is forced to incorporate trade, not just in goods and services but also financial assets. Something which models which SWL uses isn’t sophisticated enough to handle.
Moving on, SWL claims that the UK’s exit from the EU makes the UK poorer. He says:
This decline in trade leads to a loss in productivity which makes UK citizens poorer over the medium term. It also means that the real value of sterling has to fall to make up for the fall in net exports. Other things being equal, this fall in sterling will happen immediately, as indeed it already has. This will make people poorer immediately, because imported goods cost more. But here the macroeconomics gets complicated. The hit to trade from leaving the single market will evolve gradually, but the fall in sterling is immediate. (The reason is something economists call UIP.) That means that trading firms might get a short term competitiveness boost, even though this will evaporate in the medium term. This may or may not be enough to compensate for the short term impact of rising prices on consumption spending.
Unfortunately that is not all that happens in the short term. Uncertainty about future arrangements will hold back investment, and it may also add to the depreciation in sterling. For this and other reasons the short term impact on aggregate demand is likely to be negative, although measuring its size is difficult. We then need to think about whether the MPC will raise or cut interest rates. The National Institute’s analysis is very readable on all this.
[underlying: mine]
So the claim that it will make the UK poorer. In effect, SWL’s model is telling him that real GDP will fall as well as real wealth as well fall in real household expenditure. There are several ways in which it happens. Productivity falls. Fall in productivity leads to a less than rapid increase in production. Consumer prices rising means lower real expenditure and so on.
Now, in Kaldorian story the causalities in the real story of actual economic dynamics are almost reverse than the ones presented above. Faced will less free trade, the UK government is less constrained to expand domestic demand and output. It can protect its manufacturing industry. Rising production leads to rising productivity, reverse of what is implied by SWL’s model. True, imported goods will be costlier, but it also reduces import penetration which allows domestic demand to be expanded and hence output and hence real national income and household income so that consumers are more than compensated for imports being made more expensive.
Of course, all this depends on whether the UK government reduces austerity and expands domestic demand. But some effects can be seen, although uncertain. This is because the foreign trade multiplier is improving and the fiscal policy multiplier improves, even if the fiscal stance is not changed. Higher wages if immigration is controlled also provides a boost to demand.
At any rate, the important point in this post is that the remain campaign’s economics is a model which is completely erroneous about causalities and how economies work.
In the previous post, I highlighted Nicholas Kaldor’s view on the EU. I want to quote Wynne Godley’s views as well. Wynne Godley was highly influenced by Nicholas Kaldor so it is not surprising his views were similar.
In an article Wynne Godley Asks If Britain Will Have To Withdraw From Europe, written for London Review Of Books, written in October 1979, Godley writes:
The implications for Britain of EEC membership are rapidly becoming so perversely disadvantageous that either a major change in existing arrangements must be made or we shall have, somehow, to withdraw.
I strongly support the idea of Britain’s membership of the Common Market for political and cultural reasons. I would also support co-ordinated economic policies which were mutually advantageous to all the member countries. But this is not what we have got at the moment.
…
So we are all to be losers. The taxpayer through the Budget contribution, the consumer through higher food prices, the farmer through costs rising more than selling prices, and the manufacturer through rapidly rising import penetration.
…
… And if we may also take into account the dynamic effects, our balance of payments would be better by several thousand million pounds than it is at present. This would by itself have had a favourable effect on real national income and output, but, more important, it would have enabled the Government to pursue a less restrictive fiscal and monetary policy. According to preliminary estimates, the real national income could have been at least 10 per cent higher than at present and the rate of price inflation several points lower than if we had never joined the EEC.
It’s the United Kingdom European Union membership referendum tomorrow. In my opinion, the UK should leave the EU.
When discussing the Euro Area, it is emphasized frequently that Euro Area governments do not have the power to make expenditures by making drafts at the central bank as argued by Wynne Godley in 1992:
It needs to be emphasised at the start that the establishment of a single currency in the EC would indeed bring to an end the sovereignty of its component nations and their power to take independent action on major issues. As Mr Tim Congdon has argued very cogently, the power to issue its own money, to make drafts on its own central bank, is the main thing which defines national independence. If a country gives up or loses this power, it acquires the status of a local authority or colony. Local authorities and regions obviously cannot devalue. But they also lose the power to finance deficits through money creation while other methods of raising finance are subject to central regulation. Nor can they change interest rates.
The Euro Area was formed because Europeans wanted to come together and create a union which is big and powerful enough to be not affected by financial markets. The original intent was right but soon the whole idea came to be influenced by neoliberalism. The thing which was hugely missing (“the incredible lacuna” in Wynne Godley’s words in the above cited article) was the absence of central government of the Euro Area itself, which will have the power to collect taxes from Euro Area economic units and make expenditures. After some years of boom, the Euro Area found itself in crisis and could not deal with it well because there was no central government and fiscal policy to the rescue. The European Central Bank tried to save the monetary union but isn’t as powerful enough as a central government. More importantly, the Euro Area was brought into existence with the idea of free trade. Not only was power taken away from relatively economically weaker nations such as Greece but free trade was imposed by bringing their producers compete in the common market. In summary, there were two reasons why some Euro Area nations suffered.
Typically the former is emphasized more than the latter. Perhaps the reason is simple. It is easier to explain the former than the latter. In my experience, the latter is more difficult for people to understand and appreciate. Very few have emphasized it. Few exceptions are: Nicholas Kaldor, Wynne Godley.
Because economic growth is “balance of payments constrained”, free trade is devastating. The Euro Area could have had free trade if it had a central government which keeps imbalances in check because of fiscal transfers and regional policies.
Which brings us to the European Union itself and Britain’s membership. Although the UK government neither didn’t surrendered its sovereignty to make drafts at the central bank nor irrevocably fix the exchange rate in 1999, the nations’ producers still compete in the common market. It is better off leaving the European Union and have powers to impose tariffs on imports. Free trade is destructive to trade and one needs a lot of protection – at least the power of the optionality to impose such things any time a nation needs.
It was surpising to see less heterodox noise on this.
Nicholas Kaldor wrote a lot on this in the 1970s before the United Kingdom European Communities membership referendum in 1975. In his Collected Economics Essays, Volume 7, Nicky wrote (Introduction, page xxvi, October 1977) :
The final section of this volume, Part III, reproduces papers written in the course of the “Great Debate” on the question of British Membership of the Common Market in 1970 and 1971, and includes as a postscript a lecture on Free Trade written in 1977. As this debate came to an end when Britain entered the market, a decision which was later confirmed in popular referendum with a 2:1 majority, the reproduction of these papers may strike as otiose and serving little purpose other than somewhat ignoble one of self-vindication in the eyes of future historians. However, if the long-run effects of our membership turn out to be as disastrous as I feared they would be in 1971—and nothing that has happened has caused me to change my views—I think it is of the utmost importance that the true arguments against membership should be accessible to successive generations of students, the more so since the political debate continues to be dominated by issues (such as our effects of membership on the cost of food, on our agriculture, or the net budgetary cost of membership) which I regard as secondary and which could be brushed aside if the long-run effects on Britain’s manufacturing industry and on our capacity to provide employment were favourable.
…
[page xxviii] … the last essay of this volume, “The Nemesis of Free Trade”, which recounts the arguments in the great debate on Free Trade and Protection conducted at the beginning of this century between Herbert Asquith and Joseph Chamberlain. The points made on both sides seem to have lost none of their freshness or relevance in the intervening years. What has changed is our freedom to act. In 1905 we were free to decide whether to continue with the policy of free imports or to protect our industries. In 1977 the choice is no longer open to us, except at a political cost of withdrawing from the Common Market, an act which few people would contemplate seriously so soon after accession.
But after so many years, here is the chance to undo all this and withdraw from the EU. The UK should leave the EU.
A lot has been written on helicopter money recently. Most of them bad with a few exceptions such as one by JKH.
In my opinion, the main reason economists come up with stories such as “helicopter money” etc. is that it is difficult in standard economic theory to introduce money.
Few quotes from Mervyn King’s book The End of Alchemy: Money, Banking, and the Future of the Global Economy:
But my experience at the Bank also revealed the inadequacies of the ‘models’ – whether verbal descriptions or mathematical equations – used by economists to explain swings in total spending and production. In particular such models say nothing about the importance of money and banks and the panoply of financial markets that feature prominently in newspapers and on our television screens. Is there a fundamental weakness in the intellectual economic framework underpinning contemporary thinking? [p 7]
For over two centuries, economists have struggled to provide a rigorous theoretical basis for the role of money, and have largely failed. It is a striking fact that as as economics has become more and more sophisticated, it has had less and less to say about money… As the emininent Cambridge economist, and late Professor Frank Hahn, wrote: ‘the most serious challenge that the existence of money poses to the theorist is this: the best developed model of the economy cannot find room for it’.
Why is modern economics unable to explain why money exists? It is the result of a particular view of competitive markets. Adam Smith’s ‘invisible hand’ …
… Money has no place in an economy with the grand auction. [pp 78-80]
But the ex-Bank of England governor perhaps never worked with stock flow consistent models. The advantage of these models is that what money is and how it is created is central to the question of how economies work. The framework used in stock flow consistent models is not new exactly. What’s new in stock-flow consistent models is the behavioural analysis on top of the existing framework the system of national accounts and flow of funds. As Morris Copeland, who formulated the flow of funds accounts of the U.S. economy said:
The subject of money, credit and moneyflows is a highly technical one, but it is also one that has a wide popular appeal. For centuries it has attracted quacks as well as serious students, and there has too often been difficulty in distinguishing a widely held popular belief from a completely formulated and tested scientific hypothesis.
I have said that the subject of money and moneyflows lends itself to a social accounting approach. Let me go one step farther. I am convinced that only with such an approach will economists be able to rid this subject of the quackery and misconceptions that have hitherto been prevalent in it.
– Morris Copeland, Social Accounting For Moneyflows in Flow-of-Funds Analysis: A Handbook for Practitioners (1996) [article originally published in 1949]
So what do we mean by helicopter money and it is really needed or useful? For that we need to go into a bit into some behavioural equations in stock-flow consistent models. One way is to use a somewhat simplified notation from Tobin’s nobel prize lecture Money and Finance in the Macroeconomic Process. In Tobin’s analysis, the government’s fiscal deficit is financed by high-powered money and government bonds:
G – T = ΔH + ΔB
ΔH = γH·(G – T)
ΔB = γB·(G – T)
γH + γB = 1
0 ≤ γH, γB ≤ 1
So the deficit is financed by “high-powered money” (H) and government bonds (B) in proportion γH and γB
Now it is important to go into a bit of technicalities. Prior to 2008, central banks implemented monetary policy by a corridor system. After 2008, when the financial system needed to be rescued and later when central banks started the large scale asset purchase program (“QE”), central banks shifted to a floor system.
Although economics textbooks keep claiming that the central bank “controls the money supply”, in reality they are just setting interest rates.
In the corridor system, there are three important rates:
There are many complications but the above is for simplicity. Typically the target rate is mid-way between the lower (deposit rate) and the higher (lending rate).
In the floor system, the government and the central bank cannot set the overnight at the target rate if the central bank doesn’t supply as much reserves as demanded by banks. Else the interest rate will fall to the deposit rate or rise to the lending rate. In a system with a “reserve-requirement”, banks will need an amount of reserves deposited at the central bank equal to a fraction of deposits of non-banks at banks.
So,
H = ρ·M
where M is deposits of non-banks at banks and ρ is the reserve requirement. In stock-flow consistent models, M is endogenous and cannot be set by the central bank. Hence H is also endogenous.
In the floor system, the target rate is the rate at which the central bank pays interest on deposits. Hence the name “floor”. There are some additional complications for the Eurosystem, but let’s not go into that and work in this simplification.
In the floor system, the central bank and the government can decide the proportions in which deficit is financed between high powered money and government bonds. However since deposits are endogenous the relation between high powered money and deposits no longer holds.
In short,
In a corridor system, γH and γB are endogenous, M is endogenous and H = ρ·M. In a floor system, γH and γB can be made exogenous, M is endogenous and H ≠ ρ·M. M is not controlled by the central bank or the government in either cases and is determined by asset allocation decisions of the non-bank sector.
Of course, the government deficit G – T itself is endogenous and we should treat the government expenditure G and the tax-rates θ as exogenous not the deficit itself.
So we can give some meaning to “helicopter money”. It’s when the central bank is implementing monetary policy by a floor system and γH and γB are exogenous.
But this doesn’t end there. there are people such as Ben Bernanke who have even proposed that the central bank credit government’s account with some amount and let it spend. So this introduces a new variable and let’s call it Gcb.
So we have a corridor system with variables G and θ versus a floor system with variables G’, G’cb, θ, γ’H and γ’B
The question then is how is the latter more superior. Surely the output or GDP of an economy is different in the two cases. However people constantly arguing the case for “helicopter money” are in the illusion that the latter case is somewhat superior. Why for example isn’t the vanilla case of a corridor system with higher government expenditure worse than “helicopter money”.
Also it effectively reduces to a fiscal expansion combined with a large scale asset purchase program of the central bank (“QE”). I described QE’s effect here. Roughly it works by a wealth effect on output with some effect on investment via asset allocation.
To summarize, the effect on output by these crazy ways can be achieved by a higher fiscal expansion. There’s hardly a need to bring in helicopters. Some defenders say that it is faster but that just sounds like an excuse to not educate policymakers.
It’s fairly common for economists to confuse accounting identities and behavioural relationships.
Question: What is the best way to find it?
Answer: The behaviour of output (at home and abroad) is not discussed in their analysis.
It’s not always the case that it’s true but a good way to find – check whether the economist is talking of the effect of changes in stocks or flows on output.
It’s also of course important to discern what someone is literally saying and what that person is trying to say. Economists aren’t the best communicators. For example, consider the sentence: “(fiscal) deficits increase growth and surplus reduces it”. This is far from accurate because the fiscal deficit is an output of a model (and everyone has a model implicitly), not an input. It’s better to state whether the fiscal policy under discussion is expansionary or contractionary. So let’s say that private expenditure rises relative to income for whatever reason, such as expectations of the future. This leads to a rise in output and hence taxes and the fiscal deficit will reduce and we have a rise in output coincident with a fall in fiscal deficit. But neither fiscal deficit or surplus caused that growth. At the same time, one should also try to check what the narrator is trying to say. So if someone says “deficit spending is needed”, he or she is actually trying to say, “an expansionary fiscal policy is needed”.
It doesn’t harm to be accurate or try to be accurate.
One of the worst mistake of this kind being discussed is using the identity (in the case of a closed economy):
G − T = S − I
where G, T, S and I are government expenditure, taxes, private saving and private investment respectively.
A careless look at this would led one to conclude that “deficits reduce investment”. What the economist who claims this is saying is that an fiscal expansion (rising government expenditure and/or reduced tax rates) decreases investment. The error in this is that, saving is thought to be constant. However, using a Keynesian stock-flow consistent model, it is not difficult to see that a fiscal expansion has an expansionary effect on output which will raise private investment and also private saving (assuming saving propensities are constant).
More generally, the equation is:
G − T + CAB = S − I
in the general case of the open economy. In the above CAB is the current account of the balance of payments. Also balance of payments accounting tells us that current account balance is equal to the net lending to the rest of the world. In the old balance of payments terminology, this is equal to the negative of the capital account balance.
So we have:
CAB + KAB = 0
Or
NL = CAB
in the modern balance of payments terminology, where NL is the net lending of resident economic units to the rest of the world.
This has led to various theories about how what causes trade imbalances. A careless conclusion which can be drawn by looking at the last equation is that an increase in private saving or a reduction in the government expenditure reduces the trade balance. Although in this case it’s true, this happens via a reduction of output.
Another strange hypothesis is to say that it’s net borrowing (the opposite of net lending) from the rest of the world which causes current account deficits. Some authors such as Michael Pettis have taken this to extreme.
Wynne Godley was one economist who made heavy use of the accounting identity.
G − T + CAB = S − I
In his view, the causal relationship linking the balances is via output at home and abroad.
In his 1995 article, A Critical Imbalance in U.S. Trade he says:
… an accounting identity, though useful as a basis for consistent thinking about the problem can tell us nothing about why anything happens. In my view, while it is true by the laws of logic that the current balance of payments always equals the public deficit less the private financial surplus, the only causal relationship linking the balances (given trade propensities) operates through changes in the level of output at home and abroad. Thus a spontaneous increase in household saving or a spontaneous reduction in the budget deficit (say, as a result of cuts in public expenditure) would bring about an improvement in the external deficit only because either would induce a fall in total demand and output, with lower imports as a consequence.
In this post, I want to highlight how capital flows can impact trade balances using my experience with experimenting with stock flow consistent models. Before that, it’s important to note a few things which are often forgotten.
An import by a resident economic unit is a decision to purchase a good or a service produced by a non-resident producer. Similarly exports of a nation is indicative of the relative competitiveness of producers at home in international markets. It cannot be said to be caused solely by capital flows. But it’s not so simple. Imports for example depend on incomes of resident economic units and capital flows can have an impact on imports because they can affect output and income.
But it’s vacuous to say that current account imbalances are caused solely by capital flows as many economic commentators claim implicitly or explicitly.
It’s easy to commit the mistake and think that imports depend solely on prices of goods and services. The world is not so simple. If every good or service is exactly the same, then it’s all about prices. However, producers produce thousands of different goods and services. So both price and non-price factors matter in determining imports. Even for similar goods, such as cars, consumers tend to prefer foreign produced cars over domestically produced ones even if the former is much more expensive simply because consumers are not just looking at the price but also quality, durability, looks and design and so on.
So both price competitiveness and non-price competitiveness are important. The way these things are modelled in literature is by using price and income elasticities. Imports depend on price via terms involving price and price elasticities and on income via terms involving income and income elasticities.
Where can we then look for causal connection of impact of capital flows on trade balance?
Before this it is important to keep in mind that gross capital flows can be compensated gross flows in the other direction. So to look for a causal connection in the accounting identity:
NL = CAB (or “CAB + KAB = 0″)
is silly to begin with.
So here are some ways in which capital flows can cause have an impact on trade balances.
On Twitter, T Srinivas mentioned to me that desire to accumulate reserves may cause nations to depress demand and hence lead to lower exports for other nations, citing the example of events following the Asian Crisis in the late 90s. This is partly included in 8. Although I don’t disagree, my points are more about flows caused due to changes in investor preferences themselves.
Of course it touches an important point. Low domestic demand and output in “surplus” nations leads to a positive net lending to the rest of the world. It’s more accurate to say that the current account deficit of “deficit” nations is because of low domestic demand and output than because of capital inflows to those “deficit” nations. So it’s not “saving glut” but demand shortage, beggar-my-neighbour policies.
In conclusion it is counterproductive to use the accounting identity
NL = CAB
(or the same identity in the slightly misleading language CAB + KAB = 0) to claim a causation from capital flows to current account balance.
An example is this paragraph from Michael Pettis:
… This is one of the most fundamental errors that arise from a failure to understand the balance of payments mechanisms. As I explained four years ago in an article for Foreign Policy, “it may be correct to say that the role of the dollar allows Americans to consume beyond their means, but it is just as correct, and probably more so, to say that foreign accumulations of dollars force Americans to consume beyond their means.” As counter-intuitive as it may seem at first, the US does not need foreign capital because the US savings rate is low. The US savings rate is low because it must counterbalance foreign capital inflows, and this is true out of arithmetical necessity, as I showed in a May, 2014 blog entry (link broken: archive.is link).
It’s an extreme viewpoint. During the crisis, there was a large foreign demand for US public debt but this didn’t cause a rise in U.S. imports. Similarly, a central bank intervening in the foreign exchange market and buying U.S. dollars from U.S. resident economic units doesn’t cause U.S. imports to rise in the few seconds. (Accounting identities also hold for time periods of seconds!) It’s balanced by gross U.S. capital outflows.
Capital flows can impact trade balances but it has really nothing to do with this identity. The causal link is still output and home and abroad (and some due to price changes of goods and services due to exchange rate movements).
Two things caught my attention in the last two days.
First is the claim by Roger Farmer:
The Keynesian economics of the General Theory is static.
That’s the strangest critique of the GT I have ever seen. How is the GT static? John Maynard Keynes highlighted how a fall in the propensity to consume reduces output. His mechanism was quite dynamic. He was arguing that a fall in the propensity to consume will reduce consumption and hence firms’ sales and hence production and hence employment and hence consumption and so on. Keynes did not explicitly write down a mathematical model like as done for example in the book Monetary Economics by Wynne Godley and Marc Lavoie. But his arguments were quite dynamic in nature. So was his argument about how investment creates saving. And also the Keynesian multiplier. “Stock-flow consistent” models are quite close to Keynes’ spirit.
The second is this paragraph from Michael Pettis:
… This is one of the most fundamental errors that arise from a failure to understand the balance of payments mechanisms. As I explained four years ago in an article for Foreign Policy, “it may be correct to say that the role of the dollar allows Americans to consume beyond their means, but it is just as correct, and probably more so, to say that foreign accumulations of dollars force Americans to consume beyond their means.” As counter-intuitive as it may seem at first, the US does not need foreign capital because the US savings rate is low. The US savings rate is low because it must counterbalance foreign capital inflows, and this is true out of arithmetical necessity, as I showed in a May, 2014 blog entry (link broken: archive.is link).
Oh boy! That’s confusing accounting identities with behaviour. A simple way to show how inaccurate this is by using standard Keynesian analysis. Assume US households reduce the propensity to consume. This leads to a fall in output and income and hence a fall in imports and an increase in the current account balance of payments (assuming exports are exogenous to the model). This can be seen more precisely in a stock-flow consistent model.
Pettis’ arguments are in response to Stephen Roach’s recent article on US balance of payments and I discussed that recently here. Both Roach and Pettis are incorrect.
Balance of payments is important and in my opinion, the most important thing in Economics. Michael Pettis gets the attention because he realizes the importance of balance of payments in the economic dynamics of the world. However looked more closely, many of his arguments appear vacuous.