Author Archives: V. Ramanan

Exorbitant Privilege

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My last post was on U.S. net income payments from abroad and how it continues to be in the favour of the United States. The late Wynne Godley had been analyzing this since 1994. In an article titled U.S. Trade Deficits: The Recovery’s Dark Side?, written with William Milberg, he had a section called “Foreign indebtedness and the foreign income paradox” where he said:

So far, the practical consequences of the United States having become “the world’s largest debtor” have not been all that significant… But it would be an error to suppose that, because the net return on net assets has been negligible in the recent past, the same thing will be true in the future…

… Why did the net foreign income flow remain positive for so long after 1988? In order to understand this apparent paradox, it is essential to disaggregate stocks of assets and liabilities and their associated flows, and to distinguish (in particular) between financial assets and direct investments… The reason that net foreign income remained positive for so long can now be understood (at least up to a point) by making a comparison of the flows shown in Figure 3 with the stocks shown in Figure 2. The net inflow that arises from direct investment has been roughly equal to the net outflow on financial assets in recent years, even though the stock of financial liabilities has been about five times as large as the market value of net foreign investments. In other words, the rate of return on net direct investments far exceeded the rate on net financial liabilities

Figure 2 referred to is below:

and Figure 3:

which is what I redrew with updated data in my previous post. But as we saw the net income payments from abroad continues to be positive (!!) even till date but the reason is similar. Foreign direct investment in the United States has risen to $2.8T at the end of 2011 as per Federal Reserve’s Z.1 Flow of Funds while U.S direct investment abroad rose to $4.8T – significantly higher (even as a percent of GDP) than in the mid-90s.

The net direct investment has seen huge returns (both via income and holding gains) and so this killing has brought in good fortunes for the United States. Of course with the whole current account of balance of payments in deficit, the external sector bleeds the circular flow of national income in the United States and contributes to weak demand there.

So a current account deficit is bad for the United States but financing this deficit has been easy for the United States given that the US Dollar is the reserve currency of the world. Why do nations require reserve assets? The late Joseph Gold of the IMF gave a nice description in his book Legal and Institutional Aspects of the International Monetary System: Selected Essays:

click to view on Google Books

What makes the US dollar the reserve currency of the world is difficult to argue. However it cannot be taken for granted that the United States may enjoy this exorbitant privilege given that the Sterling was once the darling of the financial markets and central banks.

After writing the previous post, I came across this interesting paper From World Banker To World Venture Capitalist – U.S. External Adjustment And The Exorbitant Privilege by Pierre-Olivier Gourinchas and Hélène Rey written in 2005.

Their argument is similar – direct investments have made huge returns for the domestic private sector of the United States and gives a good account of the external sector. Here’s a graph of the United States’ net international investment position using data reported by the Federal Reserve’s Z.1 Flow of Funds Accounts as well as the BEA’s International Investment Position:

Why the difference is a topic for another post. I don’t know it yet. Gourinchas and Rey have some answers. The Federal Reserve’s data is till 2011 end and quarterly (and seasonally adjusted) while BEA data is yearly and available till 2010.

So, from the graph above, the United States became a net debtor of the world around 1986. The indebtedness has been rising mainly due to the huge current account deficits the nation manages to run and is partly offset by “holding gains”.

Here’s a graph of the current account deficit plotted with other “financial balances” (since they are related by an identity)

I also discuss this in my post The Un-Godley Private Sector Deficit.

By the way, the U.S. was a creditor of the world when the Bretton Woods system of fixed exchange rates collapsed. Some authors describe this collapse by saying that money has become fiat since 1971 – whatever that means!

Gourinchas and Rey point out – correctly in my opinion:

The previous discussion points to a possible instability, even in an international monetary system that lacks a formal anchor. The relevant reference here is Triffin’s prescient work on the fundamental instability of the Bretton Woods system (see Triffin 1960). Triffin saw that in a world where the fluctuations in gold supply were dictated by the vagaries of discoveries in South Africa or the destabilizing schemes of Soviet Russia, but in any case unable to grow with world demand for liquidity, the demand for the dollar was bound to eventually exceed the gold reserves of the Federal Reserve. This left the door open for a run on the dollar. Interestingly, the current situation can be seen in a similar light: in a world where the United States can supply the international currency at will and invests it in illiquid assets, it still faces a confidence risk. There could be a run on the dollar not because investors would fear an abandonment of the gold parity, as in the 1970s, but because they would fear a plunge in the dollar exchange rate. In other words, Triffin’s analysis does not have to rely on the gold-dollar parity to be relevant. Gold or not, the specter of the Triffin dilemma may still be haunting us!

Gourinchas and Rey’s arguments depend on estimating a tipping point – the point where the net income payments from abroad turn negative. This of course depends on various assumptions but let us look at it.

The gross assets of the United States held abroad and liabilities to foreigners keep changing as the nation is able to increase its liabilities and use it to make direct investments abroad. The reserve currency status has provided the nation with this privilege as central banks around the world are willing to hold dollar-denominated assets. The positive return (as well as revaluation gains from the depreciation of the dollar – when it depreciates) helps reduce the net indebtedness but the current account deficit contributes to increasing it.

The following is the graph of gross assets and liabilities – using the Federal Reserve’s Z.1 Flow of Funds Accounts data and also BEA’s data for the ratio:

So assuming assets held abroad A make a return rA and liabilities L to foreigners lead to payments at an effective interest rate rL income payments from abroad will turn negative whenever

rA · A − rL · L < 0

So A and L are changing due to the current account deficits and revaluation gains on assets and liabilities. Meanwhile, the effective interest rates are themselves changing in time because of various things such as short term interest rates set by the central banks, market conditions, state of the economy etc. Also, if the private sector of the United States makes more direct investments abroad, this will contribute to increase rA (if successful) and the process can go on with net income payments from abroad staying positive for longer. The tipping point is defined by Gourinchas and Rey as the ratio L/A beyond which the the net income payments turn negative. According to their analysis (based purely on historical data), this is 1.30.

If the net income payments from abroad turns negative, international financial markets and central banks may start suspecting the future of the exorbitant privilege according to the authors. Of course, it may be the case that even if it turns negative, the United States’ creditors don’t mind – this has been the case of Australia. The following is from the page 18 of the Australian Bureau of Statistics release Balance of Payments and International Investment Position, Australia, Dec 2011 and in their terminology – which is the same as the IMF’s – it is called “net primary income”)

(Australia’s Q4 2011 GDP was around A$369bn for comparison) and the above graph is quarterly.

So, to conclude the process can continue as long as foreigners do not mind. It shouldn’t be forgotten however that Australian banks had funding issues during the financial crisis and the RBA used its line of credit at the Federal Reserve via fx swaps to prevent a run on Australian banks and it is difficult to design policy without keeping in mind the possibility of walking into uncharted territory.

Once net primary income turns negative, the process can quickly run into unsustainable territory due to the magic of compounding of interest unless the currency depreciates in the favour of the nation helping exports. Else demand has to be curtailed to prevent an explosion but this hurts employment. Other policy options include promotion of exports and asking trading partners to increase domestic demand by fiscal expansion.

The Curious Case Of U.S. Net Income Payments From Abroad

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The world economy has grown over the last so many years with the United States acting as the importer of the last resort. However, the U.S. current account deficit acts to bleed the circular flow of national income and weakens demand in the States. The nation still grew because of a huge lending boom.

Today, the U.S. Bureau of Economic Analysis came out with the Q4 report on the U.S. International Transactions. According to the release,

The U.S. current-account deficit—the combined balances on trade in goods and services, income, and net unilateral current transfers—increased to $124.1 billion (preliminary) in the fourth quarter of 2011, from $107.6 billion (revised) in the third quarter. Most of the increase in the current account deficit was due to a decrease in the surplus on income and an increase in the deficit on goods and services.

So the current account balance also consists of “income payments from abroad” – a bit of wrong phrasing because all items are income/expenditure flows. The net income payments from abroad continues to surprise analysts because in spite of the net indebtedness position of the United States, this continues to be positive and in recent times has increased! (although it fell the last quarter). Many hold the belief that the United States has lower interest rates and this is the consequence of that. While it is true that interest rates outside the U.S. are in general higher, and there is some truth to the above argument, it gives one the wrong impression that it will always be the case that net income from abroad will always be positive.

The following graph shows that this intuition is misleading. Most of the contribution to the net income is due to direct investments abroad which has made a killing for the private sector and the reverse – direct investment receipts for foreigners has made next to nothing. The remaining – income from financial assets held abroad less interest/dividend paid to foreigners’ holding of U.S. financial assets is already negative!

The red line has reduced in recent times due to lower interest rates in the U.S. presumably. But the more the U.S. continues to run large current account deficits, the deeper the red line will grow – pulling the black line to zero and into the negative territory.

The net income payments from abroad is more a result of the huge killing the U.S. domestic private sector has made abroad than because of lower interest rates. For example, excluding FDI, the data from BEA suggests that the “effective interest rate” on U.S. liabilities was 1.42% in 2010, while that on U.S assets held abroad is 1.65%. This differential will not be sufficient to keep the income payments to foreigners bounded. I used the 2010 data because the International Investment Position is available only till 2010 and the one for end of 2011 will be released only mid-2012.

To understand this, consider the case when the U.S net indebtedness grows to something about 100% of GDP due to the continuous current account deficits – if market forces allow the whole process to go on(!). This is an involved analysis involving some growth assumptions and the fiscal stance in the U.S. and the rest of the world. For example, people frequently forget that a higher growth in the U.S. will also bring in higher current account deficits. But it can easily be shown that the red and the black lines above grow into a negative territory if the United States wants to quickly achieve full employment by fiscal policy alone. 

Of course the above graph shows that there is a lot fiscal expansion can achieve in the medium term for the United States.

These numbers look “small” and can lead one into believing that “all is well”. And this is another mistaken view. For example if there is a drastic relaxation of fiscal policy by the U.S. government, the current account deficit will soon hit 6-8% of GDP which may require further relaxation of fiscal expansion to compensate the leakage of demand due to the current account deficit and with income payments turning negative due to higher indebtedness, this will turn into an unsustainable path because the current account deficits and net indebtedness will keep increasing relative to GDP. This will need interest rate hikes to attract foreigners but turns the whole process unsustainable unless one believes in the foreign exchange market doing the trick. Also currently the interest rates are low because the Federal Reserve has kept them artificially low and foreigners do not mind holding U.S. dollar assets at this rate. As William Dudley says interest rates will be raised at some point by the Federal Reserve and this will increase payments to foreigners. See this post William Dudley On U.S. Sectoral Balances

Of course, this is not the only scenario and there’s a lot fiscal policy can achieve in the medium term but it is important to keep in mind that something needs to be done with the external sector to bring the external sector in balance to achieve full employment.

Update: corrected some numbers

Kalecki’s Profit Equation

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In my post The Transactions Flow Matrix, I went into how a full transactions flow matrix can be constructed using a simplified national income matrix. Let us reanalyze the latter. The following is the same matrix with some modifications – firms retain earnings and there are interest payments.

FU is the undistributed profits of firms. From the last line we immediately see that

SAVh + FU – If – DEF = 0

or that

FU = If + DEF – SAVh

This is Kalecki’s profit equation which says among other things that firms’ retained earnings is related to the government deficit! The equation appears in pages 82-83 of the following book by Michal Kalecki:

click to view on Google Books

In their book Monetary Economics, Wynne Godley and Marc Lavoie say this in a footnote:

Note that neo-classical economists don’t even get close to this equation, for otherwise, through equation (2.4), they would have been able to rediscover Kalecki’s (1971: 82–3) famous equation which says that profits are the sum of capitalist investment, capitalist consumption expenditures and government deficit, minus workers’ saving. Rewriting equation (2.3), we obtain:

FU = If + DEF − SAVh

which says that the retained earnings of firms are equal to the investment of firms plus the government deficit minus household saving. Thus, in contrast to neo-liberal thinking, the above equation implies that the larger the government deficit, the larger the retained earnings of firms; also the larger the saving of households, the smaller the retained earnings of firms, provided the left-out terms are kept constant. Of course the given equation also features the well-known relationship between investment and profits, whereby actual investment expenditures determine the realized level of retained earnings.

The above can of course also be written as:

I = SAVh + SAVf + SAVg = SAV

if one realized that the retained earning of firms is also their saving:

SAVf = FU

Business accountants know the connection between retained earnings and shareholders’ equity and in our language – which is that of national accountants/2008 SNA – it adds to their net worth just like household saving adds to their net worth.

Assuming away capital gains, we know from many posts that:

Change in Net Worth = Saving

Where do we find the undistributed profits in the Federal Reserve’s Flow of Funds Statistic Z.1?

In Table F.102, there’s an item called “Total Internal Funds”:

(click to expand)

Balance Of Payments: Part 1

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This is the first part of a series of posts I intend to write on the “rest of the world” accounts in National Accounts. This blog is about looking at economies from the point of view of National Accounts, Cambridge Keynesianism and Horizontalism. While various descriptions of balance of payments exist, most of them simply end up making money exogeneity assumption somewhere in the description!

In my view a careful description of balance of payments offers great insights on how economies work and what money really is. It is impossible to understand the success and failures of nations without understanding the external sector.

A description in terms of stocks and flows is the most appropriate for macroeconomics. Fortunately, national accountants have a good systematic approach to this.

Consider the following transaction: a government (or a corporation) raises funds in the international markets. The buyers can be residents as well as non-residents. The currency of the new issuance can be domestic as well as foreign. Does this by itself increase the net indebtedness of the nation as a whole?

The answer is No, and can be a bit surprising to the reader because the answer is the same whether the currency is domestic or foreign. The trick in the question is that an issuance of debt increases the assets and liabilities of the issuer!

(Note: the question was about the transaction, not on what happens after this)

Gross assets and liabilities vis-à-vis the rest of the world can be a bit more complicated and we need a more systematic analysis.

Consider another transaction. A government is redeeming a 7% bond with a notional of 1bn with semi-annual coupons. How much does the net indebtedness of the country change? Assuming that all the lenders are in the rest of the world sector, the net indebtedness changes by 35m. Does not matter if the currency is domestic or not. Why 35m? Because the semi-annual coupon has to be paid on redemption and the coupons are interest payments and this is recorded in the current account and this increases the net indebtedness. The principal payment cancels out the earlier liability – the bonds.

So between the start and the end of the period, foreigners earned 35m and this increased the net indebtedness of the nation who paid the interest. Of course there are other transactions which can cancel this out.

In another scenario, if all the bond holders were residents, the net indebtedness does not change – whether the bonds were in domestic currency or not.

The above was about financing. What about imports and exports? Exports provide income to a nation or a region as a whole and imports are opposite. If a nation is a net importer (more appropriately running a current account deficit), this means its expenditure is higher than income. When expenditure is higher than income, this has to be financed and this is via net borrowing. 

There is one important point worth stressing. Many people – including many economists (most?) – treat liabilities to foreigners in domestic currency as not really a liability at all – at least the government’s liabilities. The reason provided is that while usually the government is forbidden from making an overdraft at the central bank or have limited powers in using central bank credit, it can end up making a higher use of it than the limits allowed – in extreme conditions. This in my opinion, is a silly intuition.

While it is true that the governments of most nations (with exceptions such as the Euro Area governments) can make a draft at the central bank and this offers the government protection to tide over extreme emergencies, the government has to directly or indirectly finance the current account deficits and this can prove unsustainable. Despite this there is an advantage in having indebtedness to foreigners in the domestic currency because:

An indebtedness to foreigners in domestic currency prevents revaluation losses on the debt if foreigners continue holding the debt and if the currency depreciates against foreign currencies. If the debt is denominated in a foreign currency and if it depreciates, more income needs to be earned from abroad to service the principal and interest payments.

The discussion can be confusing because of the relative ease with which the United States has managed till now to finance its current account deficits because the US dollar is the reserve currency of the world and continues to do so and the holders are willing to accept liabilities of resident sectors of the United States, especially the government’s at low interest rates/yields.

James Tobin, who has provided the best description of the meaning of government deficits and debt said this in an article “Agenda For International Coordination Of Macroeconomic Policies” (Google Books link)

Nonzero current accounts must be financed by equivalent capital movements, in part induced by appropriate structure of interest rates.

We will discuss this further in many posts and for now here’s a good illustration of how the balance of payments accounts are kept. This is from the Australian Bureau of Statistics’ manual Balance of Payments and International Investment Position, Australia, Concepts, Sources and Methods, 1998

(click to enlarge)

So, one starts out with the international investment position and records the transactions in the current account and the financial account. The difference is that the former records income/expenditure flows while the latter records financing flows. The current account includes items such as imports, exports, dividends, interest payments paid to/received from non-residents etc., while the capital account records transactions such as residents’ purchases of assets abroad, increase in liabilities to non-residents and so on. Since debits and credits equal, the balances in the two accounts cancel out. To calculate the international investment position, we add the financial account flows and calculate revaluations to reach the end of period international investment position.

The international investment position records assets and liabilities vis-à-vis the rest of the world. If the difference – the NIIP – is negative, it means the nation is a debtor nation. In the construction above, all transactions between residents and non-residents are recorded – whether in domestic or foreign currency. The numbers are then converted to the domestic currency according to the best rules prescribed by national accountants.

We will look into these in more detail – including all causalities of course – in later posts in this series. Till then, the summary is: imports are purchased on credit. 

€2.2 Trillion

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Found this graph at this hilarious blog which quotes Diapason Research. The graph plotted by the researchers uses cumulative current account balances from IMF’s data. I instead directly used the Net International Investment Position at the end of Q3 2011 from Eurostat.

The blue bars plot the net indebtedness of each EA17 nation (with signs reversed) and the red line is cumulative from left to right. It does not sum to zero because the Euro Area as a whole is a net debtor of the rest of the world.

The indebted European nations owe their creditors €2.2tn – which is almost 40% of the gdp of these nations as a whole.

An alternative way to plot the NIIP- in ascending/descending order as a percent of gdp. Readers of the Concerted Action blog will know that I love the NIIP! I just found a nicer way to plot this. The alternative graph is below:

Deutsche Bundesbank’s TARGET2 Claims

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Yesterday Wolfgang Münchau wrote an article in the Financial Times The Bundesbank has no right at all to be baffled in which he gave his opinion about Bundesbank President Jens Weidmann’s leaked letter to the European Central Bank President  Mario Draghi expressing concerns on the Bundesbank’s TARGET2 assets.

According to the Bundesbank December 2011 Monthly Report, its claims on the rest of the Eurosystem was around €476bn (and that it reduced somewhat in December!)

According to Münchau,

The Bundesbank initially dismissed the Target 2 balance as a matter of statistics. Their argument was: yes, it is recorded in the Bundesbank’s accounts, but the counterparty risk is divided among all members according to their share in the system. But last week, Jens Weidmann, president of the Bundesbank, acknowledged the Target 2 imbalances are indeed important, and an unacceptable risk. The Bundesbank has now joined the united front of German academic opinion.

and that:

One would assume that the best policies would be those that attack the root of the problem – the imbalances themselves. One of the deep causes behind this problem is, of course, Germany’s persistent current account surplus. The problem can thus easily be solved through policies to encourage Germany to raise its imports relative to its exports. You need policies that provide eurozone-wide backstops to the banking sector, and also policies to insure against asymmetric shocks. And you need to harmonise many aspects of structural policy to ensure imbalances do not become entrenched.

But there is no appetite for any of this in Germany. Instead, the Bundesbank prefers to solve the problem by addressing the funding side. Mr Weidmann proposed last week that Germany’s Target 2 claims should be securitised. Just think about this for a second. He demands contingent access to Greek and Spanish property and other assets to a value of €500bn in case the eurozone should collapse. He might as well have suggested sending in the Luftwaffe to solve the eurozone crisis. The proposal is unbelievably extreme.

This is indeed extreme but there are ones who argue that the Bundesbank’s (approximately) €476bn TARGET2 assets do not matter much – because the Bundesbank being the issuer of settlement balances of banks cannot go broke. This is from the Irish Economy Blog:

First, every national central bank in the Eurosystem currently has assets that exceed their liabilities and total Target2 credits equal Target2 liabilities. Thus, the most likely resolution of Target imbalances in the case of a full Euro breakup would be a pooling of assets held by Target2 debtors to be handed over to Target2 creditors to settle the balance. This may leave the Bundesbank holding a set of peripheral- originated assets that may be worth less that face value but this scenario would result in losses to the Bundesbank that would be far short of the current value of its Target2 credit.

Second, as Gavyn Davies discusses in this interesting FT article, central bank balance sheets are simply not the same as normal private sector balance sheets. It is unwise for central banks to go around printing money to purchase worthless assets so it is generally appropriate to insist that a central bank’s assets at least equal the value of the money it has created.

That said, should the Bundesbank end of losing a bunch of money because its Target2 credit was worth less than stated, there would be no earthly reason why the German public would need to give up large amounts of money to ensure that the Bundesbank remained “solvent”.

In a post-euro world, the Bundesbank would be one of a select number of central banks that could be counted on to print a currency likely to retain its value. Weidmann could write himself a cheque, stick it in the vaults and declare the Bundesbank to be solvent without any need to call on the German taxpayer.

I had written on this sometime back in the post Who is Germany? so I refer the reader to the post. Briefly my argument is that the TARGET2 balance is an important item in Germany’s International Investment Position. If there is a breakup of the Euro Area, then Germany’s wealth reduces. Indeed Karl Whelan has somewhat changed his position – from arguing it doesn’t matter to arguing that there will be a demand for settlement!

Matters can get worse in case there is a dreadful scenario in which the financial firms do a panic selling of assets in the Euro Area but held outside Germany and make a “flight to quality” to Germany. This by itself does not change Germany’s net international position (only gross items in IIP) but if the breakup results in a default by the “periphery”, Germany’s wealth erodes (among other assets, TARGET2 claims vanish overnight) and it can become a net debtor of the rest of the world from being a net creditor!

National Balance Sheet

In one of my recent posts, I went into the concept of “National Saving”. The stock counterpart of this is the “Net Worth”. It is calculated by first taking the nonfinancial assets within a nation’s boundary (defined appropriately on what is counted and what is not). Then one adds financial assets and liabilities. The claims within sectors of an economy cancel out because every asset has a counterpart liability and one is left with assets and liabilities with the rest of the world.

This is the SNA concept of net worth. It is done for example for the case of Australia in the following manner by the Australian Bureau of Statistics. (Link to the full release Australian System of National Accounts 2010-11)

So if a nation’s external assets are impaired for whatever reason, its wealth reduces. It doesn’t matter if it is the central bank whose assets are impaired. This is counter-intuitive because no sector immediately may “feel the pinch” due to the central bank’s loss of assets held abroad.

That’s a bit of Mercantilism. It is true that Mercantilist policies “injures everyone alike” as argued by Keynes himself and later by many Post Keynesians (such as Basil Moore whom I quoted in this post). However, it cannot be argued that a potential asset impairment of the Bundesbank’s TARGET2 balance does not cost the German taxpayer. So the Bundesbank would indeed go behind debtor nations and ask them to settle claims!

Needless to say, this is no defense of Weidmann’s position!

Recycling Old Posts

Here are some related posts on basics of TARGET2 and the Eurosystem: The Eurosystem: Part 1, Part 2, Part 3, Part 4, & Part 5.

Ya He Averiguado Lo Que Es La Economía

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– es la ciencia de confundir los stocks con los flujos.

Or …

I have found out what economics is; it is the science of confusing stocks with flows.

– A verbal statement by Michal Kalecki, circa 1936, as cited by Joan Robinson, in ‘Shedding darkness’, Cambridge Journal of Economics, 6(3), September 1982, 295–6 and quoted in Monetary Economics written by Wynne Godley and Marc Lavoie. And that’s how Chapter 1 starts and the authors aim to straighten out the messes of the profession and set the confusions straight!

Javier López Bernardo has translated the book in Spanish and here’s the publisher’s website for the book. The publisher’s preview is here.

The author has also implemented the models in Microsoft Excel and you can find them here. I try do that myself but it’s not in such a neat form.

William Dudley On U.S. Sectoral Balances

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Discussions of the U.S. public debt and fiscal deficits curiously miss on the connection with the external sector. Even the Congressional Budget Office (CBO)’s The Budget And Economic Outlook report misses this connection when projecting the public debt over many scenarios.

Last week the President of the Federal Reserve Bank of New York, William Dudley gave a speech at a “Panel Discussion on Fiscal Challenges” and the two topic discussed by him were: the interest expense of the US government on its debt  and the U.S. sectoral balances.

According to him, “we are in an unusual period in which net interest expense is temporarily depressed”. You can read about it at the FRBNY web page of the speech.

Which brings me to his discussion on sectoral balances. This is not the first time he has talked on this and the public debate on the public debt and fiscal deficit of the United States almost always miss the important connection of this with the external sector imbalance. But Dudley knows the importance of this in policy making, even though he begins his talk by saying that discussion of fiscal policy “for central bankers [is] always dangerous waters to swim in”.

Here’s Dudley’s chart:

Let’s just say Dudley is less dogmatic about fiscal policy than his colleagues because he says:

Fiscal adjustments require offsetting changes in private-sector spending and saving behavior, and in the trade sector. Prudent economic policies and international coordination can help ensure that such adjustments take place in ways that support economic activity (and, by extension also support government revenue).

and

On one hand, the U.S. economy must be reoriented toward global demand and stronger net exports. On the other hand, there will have to be offsetting adjustments elsewhere in the world. After all, on a global basis, the current account balance—properly measured—must sum to zero. This means that countries with significant trade surpluses will need to reorient their economies over time toward increasing domestic demand and running smaller trade surpluses.

National Saving

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Some of the previous posts went into the economic concept of Private Saving and Private Saving Net of Investment. For a closed economy these are:

Private Saving = Private Investment + Budget Deficit

Private Saving Net of Investment = Budget Deficit

For an open economy, we add the current balance of payments to the right of both these equations.

So we have the sectoral balances identity:

NPS = DEF + CAB

for Net Private Saving or Saving Net of Investment. Confusingly, Net Saving is used to mean Saving Net of Consumption of Fixed Capital. Consumption of fixed capital is the national accounting equivalent of depreciation but since there is a different accounting treatment, the former phrase is used.

In addition to Investment by the private sector, there’s also public investment and we need a bookkeeping concept of National Saving. 

Just like we consolidated the domestic private sector into one, we could also consolidate the whole nation for specific purposes.

First take a closed economy. Since Income = Expenditure and Saving is defined so that consumption and investment expenditures are treated differently, we have

Gross Saving = Gross Domestic Investment

To get Net Saving, one has to subtract consumption of fixed capital from both sides.

Economies however are open. Hence we need to modify the above equation. Simultaneously taking depreciation into account, we have:

Net Saving = Gross Domestic Investment – Consumption of Fixed Capital + Current Balance of Payments

Remember this Net Saving is different from the other usage which is Saving Net of Investment.

Before verifying that this is indeed the case for the United States, it is worth mentioning that the difference between saving and surplus (or financial balance) applies to the government sector as well. The following is from the Table F.8 of the Z.1 Flow of Funds Accounts of the United States.

(click to expand and click again to expand)

So in green – for the year 2001 for the United States – you see both the gross saving and saving net of consumption of fixed capital of the government sector is positive whereas the government’s budget balance is in deficit. 

This shouldn’t be surprising given we saw the same for the private sector.

Back to national saving, we can verify the identity. The current balance of payments is a nation’s income minus expenditure (only in a closed economy, these two are equal). If this is positive, the nation as a whole has a positive net lending. Else, it is a net borrower.

The identity can be seen using the numbers circled in red (and including the statistical discepancy).

The Paradox Of Thrift

The analysis above can mislead one into believing that since “saving” is a positive word, the nation as a whole should save by whatever means – such as by inducing the household sector to increase its propensity to save or aiming for a balanced budget (or worse, aiming to retire the public debt).

Both ideas are vacuous. A spontaneous increase in the propensity to save works by reducing the output and a tight fiscal stance achieves the same i.e., reducing the national saving or private saving as a whichever is the case – as a result of lower demand and output.

The Loanable Funds Fallacy

The simple accounting relations are also used in economics textbooks to promote saving in general because due to the above identity, one can be fooled into believing that a higher saving leads to higher investment. Again such ideas are promoted in public debates to argue against higher government expenditure and to even promote making balanced budget constitutional! The story goes that higher saving allows more investment because supposedly there are more funds to lend for investment.

This is based on the incorrect notion of the exogeneity of money. While this cannot be discussed in a single post, it’s where ideas of endogenous money and Horizontalism are illuminating.

Basil Moore had an article titled Saving Is The Accounting Record Of Investment, where he discusses some of the points here – never mind his claim that “total saving on an economy cannot reflect the volitional behavior of savers”. Here’s a Google Books preview from his book Shaking The Invisible Hand:

click to view on Google Books

Mercantilism

The Mercantilists observe the accounting identity about national saving and the fact that it is related to the balance of payments and conclude that foreign trade is highly important in the growth of nations and hence well being and quality of life. The connection is that saving achieved via running a trade surplus with the rest of the world increases a nation’s net worth. To promote less consumption, the same mantra of national saving is used. So it is related to the paradox of thrift.

These ideas are used in public discussions on the problem of the external sector imbalance whether one believes in Mercantilism or not (their idea of rejection of the invisible hand). An increase in the household propensity to save (achieved by whatever means) or an attempt to reduce the budget balance by a tighter fiscal stance improves the current account balance, only because it results in a lower domestic demand and output and hence higher unemployment – all undesirable. That of course does not mean that one can unilaterally relax fiscal policy but just points to a more international effort needed badly right now to solve the problem of global imbalances.

While there is some truth to Mercantilists’ view, it’s for slightly different reasons – it is advantageous so some in one sense and injures others and hence inures everyone in the end.

Here’s Basil Moore on Keynes (from his 2006 book Shaking The Invisible Hand, pp 400-402):

In the General Theory Keynes introduced open economy considerations in his discussion of Mercantilism. He argued that the Mercantilists had been correct in their belief that a favorable balance of trade was desirable for a country, since increases in foreign investment increase domestic AD exactly like increases in domestic investment:

When a country is growing in wealth somewhat rapidly, the further progress of this happy state of affairs is liable to be interrupted, in conditions of laissez-faire, by the insufficiency of the inducements to new investment. … the well-being of a progressive state essentially depends … on the sufficiency of such inducements. They may be found either in home investment or foreign investment … which between them make up aggregate investment. … The opportunities for home investment will be governed in the long run by the domestic rate of interest; whilst the volume of foreign investment is necessarily determined by the size of the favourable balance of trade. …

Mercantilist thought never supposed that there was a self-adjusting tendency by which the rate of interest would be established at the appropriate level…

In a society where there is no question of direct investment under the aegis of public authority,… it is reasonable for the government to be preoccupied … [with] the domestic interest rate and the balance of foreign trade. … when nations permit free movement of funds across national boundaries the authorities have no direct control over the domestic rate of interest or the other inducements to home investment, measures to increase the favourable balance of trade [are] the only direct means at their disposal for increasing foreign investment; and, at the same time, the effect of a favourable balance of trade on the influx of precious metals was their only indirect means of reducing the domestic rate of interest, and so increasing the inducement to home investment.

Keynes emphasized that any domestic employment advantage gained by export-led growth was a zero-sum game and “was liable to involve an equal disadvantage to some other country.” He argued that export-led growth aggravates the unemployment problem for the surplus nation’s trading partners, who are forced to engage in “an immoderate policy that (may) lead to a senseless international competition for a favourable balance, which injures all alike.” The traditional approach to improve the trade balance has been to attempt to make the domestic export and import-competing industries more competitive, either by forcing down nominal wages to reduce domestic production costs, or by devaluing the exchange rate. Keynes argued that gaining competitive gains by reducing nominal price variables would tend indirectly to foster a state of global recession. One’s trading partners would be forced to attempt to regain their competitive edge by instituting their own restrictive policies. When nations fail jointly to undertake expansionary policies to raise domestic investment and generate domestic full employment, free international monetary flows create a global environment where each nation has national advantages in a policy of export-led growth. The pursuit of these policies will lead to a race to the bottom, that “injures all alike.”

the weight of my criticism is directed against the inadequacy of the theoretical foundations of the laissez-faire foundations upon which I was brought up and which for many years I taught—against the notion that the rate of interest and the volume of investment are self-adjusting at the optimum level, so that preoccupation with the balance of trade is a waste of time.

These apposite warnings of Keynes have gone virtually unnoticed as mainstream economists have waxed enthusiastic about the benefits of liberalized financial markets and the export-led economic miracles of the Asian “Tigers,” and now the miracle of China. Modern economies have become more open than when Keynes was writing, so it is imperative that Keynes’ open economy analysis becomes better known.

Saving And Borrowing

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I recently heard from an online commentator that saving is the opposite of borrowing. While there is some “intuition” to this, the following exercise is show it is possible to have a positive saving and incur huge liabilities at the same time.

To complicate the matter the word “Savings” is used. Now, in national accounts, this word is used as a plural of saving and it ought to be given up as a substitute for wealth because it creates more confusions in discussions.

I had recently gone into an example of concepts such Saving, Net Acquisition Of Financial Assets, Net Investment in Nonfinancial Assets, Net Incurrence Of Liabilities and “Net Lending(+)/Net Borrowing(-)”.

The example I wrote in that post was buried in something abstract, so let me extract the most essential paragraphs here and add a few things.

Let us suppose:

A household earns $100 in a year (including interest payments and dividends), pays taxes of $20 and consumes $75.

He takes a loan of to finance a house purchase near the end of the year whose price is $500.

Assume that the Loan-To-Value (LTV) of the loan is 90% – which means he gets a loan of $450 and has to pay the remaining $50 from his pocket to buy the house. (i.e., he is financing the house mainly by borrowing and partly by sale of assets).

How does the bank lend – assuming the bank does the creditworthiness checks and decides to lend – simply by expanding it’s balance sheet (“loans make deposits”).

Ignoring, interest and principal payments (which we assume to fall in the next accounting period),

His Saving is +$100 – $20 – $75 = +$5.

His Net Investment in Nonfinancial Assets is +$500.

His Net Incurrence of Liabilities is +$450.

His Net Accumulation of Financial Assets is +$5 – $50 = – $45.

His Net Lending is = -$45 – (+$450) = -$495 which is Saving net of Investment ($5 minus $500). i.e., his Net Borrowing is +$495.

This means even though the person has a Saving of $5, he has incurred liability of $450 and due to sale of assets worth $45, he is a net borrower of $495 from other sectors (i.e., his net lending is -$495).

That can be confusing since Net Borrowing is $495 even though the person actually borrowed $450 from the bank.

As I have mentioned before, an alternative terminology exists where Net Acquisition of Financial Assets is used instead of Net Lending and Net Lending (to a sector) is used instead of Net Incurrence of Liabilities.

Table F.10

The Table F.10 of the Federal Reserve’s Statistical Release Z.1: Flow Of Funds Accounts Of The United States is below:

(click to expand and click again to expand)

The Flow of Funds Table F.10 may lead one to suppose that “Net Investment in Nonfinancial Assets” is Saving. Or to put it more simply one may suppose that “purchasing a house is saving”. Or worse “purchasing a house is dissaving”.

This is “Monetarist Intuition”. Here the house was purchased by incurring liabilities and sale of assets.

As we saw above – for the personal sector,

Saving = Disposable Income – Consumption.

NIPA accountants calculate it this way. But we also saw that

Saving = Net Acquisition of Financial Assets + Net Investment in Nonfinancial Assets – Net Incurrence of Liabilities

which can be verified from the table. This method is used by the Flow of Funds accountants.

As an aside, apart from definitional issues between Flow of Funds and NIPA, there can discrepancies and the following link discusses this without giving any conclusion.

click to view on Google Books