Tag Archives: balance of payments

The Economist On Germany’s Balance Of Payments

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The Economist‘s latest cover is about the German balance of payments. The subheading of its editorial says, that it “[t]he country saves too much and spends too little”.

That’s welcome, although the article claims that the German government’s policy is not mercantilist, while at the same time saying that wages have been held down to achieve more competitiveness in exports.

🤦🏻‍♂️

Anyway, it’s good that it has recognized that this is a problem for the world economy. Funnily, the editorial is still defending free trade, without realizing that the ideology is based on the assumption that market forces will resolve imbalances. If the magic of the price mechanism works, why do you need active policy?

It’s important to remember that John Maynard Keynes recognized that active policy measures are needed to resolve global imbalances. He proposed to impose a penalty on creditor nations in his plan for Bretton-Woods and also require them to take measures such as:

(a) Measures for the expansion of domestic credit and domestic demand.
(b) The appreciation of its local currency in terms of bancor, or, alternatively, the encouragement of an increase in money rates of earnings;
(c) The reduction of tariffs and other discouragements against imports.
(d) International development loans.

– page 24 of The Keynes Plan

A lot of times, people argue that the moral stand that Germany reduce its surpluses is vacuous. Germany is independent and responsible for its own decision. Who are others asking German politicians to raise domestic demand?

The answer to that is Germany makes huge gains out of its success in international trade. What if deficit nations form a union and impose high tariffs and quotas on their imports? International trade runs under a set of rules (the “rules of the game”) and other nations have a right to demand this from Germany and ask for fairer rules.

Anyway, The Economist has finally accepted what Keynes was saying 80 years ago!

Public Debt And Current Account Deficits

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Yesterday, there was an article at Vox which takes issue with a statement from Donald Trump which connects the US public debt with current account deficits.

Trump ran his campaign on dividing people, is out to destroy health care and wants a regressive system of taxation and so should be resisted. At the same time, a blanket opposition is counterproductive, especially when it is an important matter.

Vox quotes Trump:

For many, many years the United States has suffered through massive trade deficits; that’s why we have $20 trillion in debt.

In response, Vox claims:

The US trade deficit refers to the fact that the US imports more from the world than it exports. The national debt is the result of the fact that the US government spends more revenue than it collects. There’s no direct relationship between the two.

The whole article is written to claim that there is no connection. But anyone who knows the sectoral balances identity will recognize that there is a connection.

So the sectoral balances identity is:

NL = DEF + CAB

where, NL is the private sector net lending, DEF is the government’s deficit and CAB is the current account balance of payments (and is to a zeroth order approximation, exports less imports).

Of course, this is an identity and shouldn’t be confused for any behavioural hypothesis but it’s still useful in creating a narrative around a model (such as an SFC model) with behaviour for households, firms, the financial system, the government and the rest of the world.

On an average the private sector net lending is a small positive number relative to GDP (such as 2%), although it can fluctuate a lot. So for the U.S. economy, we saw that it was negative a lot in the 2000s and then reverted to a large positive just before and during the crisis.

One should of course keep in mind the correct causality connecting the three terms. What connects them is demand and output at home and abroad.

So the government’s deficit is affected by exports and imports. If there’s a large current account deficit, there’s a fall in demand and hence output and hence income and hence taxes leading to a higher government deficit than otherwise. Deficits in turn affects the public debt.

In other words, the U.S. public debt would have been lower, ceteris paribus, had the problem of the U.S. trade imbalance would have been addressed. This would have happened because of higher national income and higher taxes.

People don’t see the connection because they are comparing different nations. So for example, Japan has been successful in international trade and yet has a high public debt. In the other extreme, Australia has had large current account deficits over the years and public debt much lower than Japan (relative to GDP). But one should do a ceteris paribus comparison.

See Part 2 here: Public Debt And Current Account Deficits, Part 2

Two Hundred Years Of Ricardian Trade Theory

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Ingrid Kvangraven has a nice article, 200 Years of Ricardian Trade Theory: How Is This Still A Thing? on the blog, Developing Economics. In that, she asks how “the observation of persistent imbalances (and recurring debt crises in the deficit countries) appears to have little impact on the popularity of Ricardo’s theory.”

It’s a nice article going into details about the assumptions of the trade theory, but let me just add another perspective. New Consensus Economics is based on the assumption about the magic of prices and market forces acting to resolve imbalances. Government “intervention” (a loaded word), supposedly spoils this magic and economists are trained to think that this is the reason for crisis. So a New Consensus economist doesn’t find this to be contradictory. “Hey government, why did you interfere with the workings of the market”, an economist is likely to say.

The role of the government in this model is mainly about law and order and is supposed to balance its books. Whenever a crisis arises, economists tend to blame “fiscal profligacy” and recommend contraction of fiscal policy and “economic reforms”.

Of course, since the financial crisis started about ten years back, economists have conceded that they have been wrong about several things. Fiscal policy is one major area where this is so. But the “learned intuition” is so deeply ingrained and ramified into every corner of their minds—borrowing words from Keynes—that it is difficult for them to escape old ideas.

It’s unfortunate that Keynes didn’t stress much about this problem, which is huge. In his GT, he did have a chapter on mercantilism and discussed how the mercantilists behaved the way they behaved because of their distrust in the role of market forces in resolving imbalances. Keynes also had a plan called the Keynes Plan, before the Bretton Woods established. Keynes proposes a fine on creditor nations as well (page 23-24):

from page 23 of IMF’s document on Keynes’ Plan

Usually one only hears of this in Post-Keynesian literature but this was not all. He also proposed other responsibilities for creditors:

from page 24 of IMF’s document on Keynes’ Plan

Of course, the idea of a Bancor sounds crazy because of its similarity to the Euro. The trouble with the Euro is that there is no central government with large fiscal powers, such as in a federation like the United States. Bancor would need a world government. Nonetheless, we can still embrace Keynes’ genius that creditors should take responsibility in the rules of the game and reject Bancor. So apart from the principle of effective demand, this is one of Keynes’ biggest contribution to the history of humankind—that creditor nations have a responsibility.

Unfortunately, the world is still stuck with Ricardo’s ideas!

Dean Baker On US Manufacturing And International Trade

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The U.S. manufacturing deficit was $831 billion in 2015. The 2016 number might be out in a few days. Dean Baker has an excellent article, Painful Nonsense on Trade on his blog in which he debunks the claims of most economists that the US trade imbalance didn’t lead to job losses. He says:

… Note that the level of manufacturing employment, while it has cyclical ups and downs, is nearly constant from 1970 to 2000 at around 17 million. It plunged in the early years of the last decade as the trade deficit exploded. Most of the fall in employment was before the collapse of the housing bubble in 2008. This is what happens when a trade deficit increases from around 1.5 percent of GDP, the mid-1990s level, to almost 6.0 percent of GDP at its peak in 2005–2006 (over $1.1 trillion in today’s economy).

and also that the comparison to Germany is misleading:

DeLong also does a bit of sleight of hand in telling us that the loss of manufacturing employment is the same everywhere, pointing out that even Germany, the big success story, saw employment in manufacturing fall from about 40 percent of the labor force in 1971 to 20 percent at present. This is true, and if the United States had the same share of its workforce employed in manufacturing as Germany, we would have another 15 million manufacturing jobs.

A similar point was made by Wynne Godley in 1995! In A Critical Imbalance In U.S. Trade, The U.S. Balance Of Payments, International Indebtedness, And Economic Policy he said:

It is sometimes said that manufacturing has lost its importance and that countries in balance of payments difficulties should look to trade in services to put things right. However, while it is still true that manufacturing output has declined substantially as a share of GDP, the figures quoted above show that the share of manufacturing imports has risen substantially. The importance of manufacturing does not reside in the quantity of domestic output and employment it generates, still less in any intrinsic superiority that production of goods has over provision of services; it resides, rather, in the potential that manufactures have for expansion in international trade.

Euro Area NCBs’ TARGET2 Balance As Cumulative Accommodating Item In The Balance Of Payments

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There’s a discussion on Nick Rowe’s blog about the interpretation of TARGET2 balances of the NCBs in the Euro Area’s Eurosystem. How do we interpret this? My answer is the headline.

TARGET2 balances arise because of cross-border payment flows within Euro Area countries. Instead of going through how these arise, I assume the reader knows them. I have covered it many times in my blog and many others have written it.

Let’s work here in the approximation that the Euro Area is the world and there’s no economic activity outside it. Since cross-border flows within the Euro Area banking system and the Eurosystem are transactions between resident economic units and non-resident units, these flows will give rise to entries in the balance of payments of each nation within the Euro Area.

In the new balance of payments terminology, such as as in the sixth edition of the Balance Of Payments And International Investment Position Manual, (BPM6), there’s an identity:

current account balance + capital account balance = net lending (financial account balance).

For terminologies see this table from the guide:

balance-of-payments-overview

This is an identity but suggestive of some behaviour. The question is what is the residual in this. The current account consists of things such as exports, imports, interest payments between resident and non-resident units and so on. The capital account consists of acquisitions and disposals of non-produced non-financial assets and capital transfers. The financial account consists of things such as direct investment flows, portfolio investment flows and so on. Other than that, there’s also “reserve assets” and “other investment”.

There is a nice 1991 article by the BIS Capital flows in the 1980s: a survey of major trends. The author quotes James Meade who makes this distinction between autonomous flows and accommodative flows:

[accommodative capital flows] take place only because the other items in the balance of payments are such as to leave a gap of this size to be filled … [while] autonomous payments … take place regardless of other items in the balance of payments.

Strictly, this distinction makes sense in fixed exchange rate regimes. In floating exchange rate system, the two—accommodative and autonomous—can’t be clearly be separated.

Anyway, coming back to the Euro Area, before the crisis started, the banking system was working fine. So there would be flows in both the current account and the financial account. The goods and services balance in the current account depends on domestic demand and output at home and abroad and relative competitiveness. There’s no reason for this to be zero. Economic units engaged in the financial markets would buy and sell securities and these affect the financial account of the balance of payments of the two nations involved in the transaction. There’s no reason for balance of things such direct investment, portfolio investment (and financial derivative flows) to balance or to equal the current account balance. Since flows typically are via TARGET2, this affects banks’ balances at their NCBs. So it’s possible toward the end of the day for banks in Spain 🇪🇸 as a whole to find themselves in need for reserves (or settlement balances) and banks in say Germany 🇩🇪 to be in a situation where they have excess funds. So banks in Spain will likely contact banks in Germany to borrow funds, either for one day or more. This is because they will get a cheaper interest rate. If they borrowed from their NCB, the interest rate is slightly higher.

These borrowings and lendings give rise to other investment in balance of payments of the two nations. So in Meade’s language, this is an accomodative flow. Not all other investment items are accommodative flows and similarly, not all accommodative items are other investment items.

But as the financial crisis began in 2007, the interbank system froze. Banks didn’t lend each other much. Hence the residual was balances between the NCBs. This would arise automatically. So these flows can be said to be accommodating. The counterpart of this is banks borrowing from their NCBs.

There’s a technicality: somewhere around mid-2000s, the system was changed so that the bilateral balances of NCBs were assigned to the ECB on a daily basis.

Since the TARGET2 balance of NCBs is a stock and not a flow, they can be hence thought of as the cumulative accommodative item. Since the crisis, a lot of things have happened. The European Central Bank has taken various steps, so that banks have sufficient liquidity. Banks have been given facilities to borrow huge amounts from their NCBs for collateral at cheap rates. Later the ECB also started its asset purchase program in which it bought government bonds, ABS and covered bonds. Some of these were already in existence when the interbank markets froze. So even as interbank markets opened, they didn’t feel the need to borrow funds from banks abroad.

The IMF’s guide BPM6 says in Appendix 3 that these intra-Eurosystem claims (the TARGET2 balances) are to be recorded in Other Investment:

Intra-CUNCBs and CUCB balances

A3.46 Transactions and positions corresponding to claims and liabilities among CUNCBs and the CUCB (including those arising from settlement and clearing arrangements) are to be recorded for the central bank under other investment, currency and deposits or loans (depending on the nature of the claim) in the balance of payments and IIP of member economies. If changes in these intra-CU claims and liabilities do not arise from transactions, relevant entries are to be made under the “other adjustment” column of the IIP. Remuneration of these claims and liabilities is to be recorded in the balance of payments of CU member economies as income on a gross basis under investment income, other investment.

where CUCB and CUNCB are abbreviations for currency union central bank and currency union national central bank, respectively.

There is some similarity with “reserve assets” in the financial account of the balance of payments and the international investment position when comparing all this to a fix exchange rate regime. In the latter, when autonomous flows aren’t sufficient, the central bank may sell gold or foreign reserves in the markets. It may also engage in borrowing funds in foreign currency. These are also accommodative flows. In the Euro Area case however, the inter-NCB claims (and the assignment to the ECB) happens automatically. Also “reserve assets” don’t go below zero, while TARGET2 balances can be negative in the sense that they are in liabilities of some NCBs instead of being in assets.

The conclusion of all this is that TARGET2 is a sort of a residual finance to a whole nation which arises automatically. Some have interpreted this to conclude that this is unlimited. This is however not the case. Since the counterpart to these are banks’ borrowing from their NCBs, this is limited to how much collateral banks can provide the Eurosystem, with or without the help of their government.

Neochartalists Shifting Positions

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In a three part series, Bill Mitchell, makes the case against free trade. While this is most welcome – success and failure of nations depends on success in international trade via the principle of circular and cumulative causation – it’s quite a drastic change from what Neochartalists have claimed before. From “exports are a cost and imports benefits”, they have shifted their position. Mitchell goes on to concede:

These so-called ‘free trade’ agreements are nothing more than a further destruction of the democratic freedoms that the advanced nations have enjoyed and cripple the respective states’ abilities to oversee independent policy structures that are designed to advance the well-being of the population.

[emphasis: mine]

Neochartalists have always denied – till recently – that free trade can put a constraint on fiscal policy. They interpreted such critiques as an argument against fiscal expansion, instead of realizing that it’s possible to both argue for fiscal expansion and realize that it is constrained by balance of payments. One potential solution is import controls. Mitchell concedes that it’s required sometimes. He says:

In those cases, import controls may be justified to limit the damage to the less developed nation, despite the material benefits to the more developed nation being obvious.

[boldening: mine]

In another blog post as I noticed here, Mitchell says this while making proposals on reforming the international institutional framework:

…

2. Macroeconomic stabilisation – support for national currencies in the face of problematic balance of payments.

This function recognises that all nations should maintain sovereign currencies and float them on international markets but at the same time recognising that capital flows may be problematic at certain times and that some nations require more or less permanent assistance due to their export capacities and domestic resource bases.

There have been many critiques of Neochartalism but very few touch on this or give attention. But since international trade is the most important determinant of the rise and fall of nations, and that Neochartalism claims to be some fundamental theory of human interactions, its extreme position and shifting away from it should be noticed and critiqued, although welcomed.

In short, Neochartalism which is some sort of moral superiority on fiscal policy has accepted that free trade can put constraints on it. The solution of course is beyond the scope of this post but this shift should acknowledged when Neochartalism is discussed.

The Treaty Of Rome And Balanced Trade

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Policy Research in Macroeconomics (PRIME)’s blog Prime Economics reminds us of the Treaty of Rome, to establish a European Economic Community, first signed in 1957 which has a Chapter on Balance of Payments:

CHAPTER 2

BALANCE OF PAYMENTS

ARTICLE 104

Each Member State shall pursue the economic policy needed to ensure the equilibrium of its overall balance of payments and to maintain confidence in its currency, while taking care to ensure a high level of employment and a stable level of prices.

ARTICLE 105

  1. In order to facilitate attainment of the objectives set out in Article 104, Member States shall co-ordinate their economic policies. They shall for this purpose provide for co-operation between their appropriate administrative departments and between their central banks. The Commission shall submit to the Council recommendations on how to achieve such co-operation.
  2. In order to promote co-ordination of the policies of Member States in the monetary field to the full extent needed for the functioning of the common market, a Monetary Committee with advisory status is hereby set up. It shall have the following tasks:
    – to keep under review the monetary and financial situation of the Member States and of the Community and the general payments system of the Member States and to report regularly thereon to the Council and to the Commission;
    – to deliver opinions at the request of the Council or of the Commission or on its own initiative, for submission to these institutions.

The Member States and the Commission shall each appoint two members of the Monetary Committee.

I have emphasized many times in my blog that Euro Area balance of payments and international investment position imbalances are quite important for the Euro Area. Even before I started writing this blog, I had stressed before anyone else (on other Post-Keynesian blogs) that the imbalances are large and quite important in understanding the crisis.

Of course, imbalances can be corrected by deflating demand and output as has been the case in the Euro Area since the start of the crisis by policy makers. But it’s good to know that the founders of European integration thought of coordinating policies, which implies their policies would have been expansionary. Anyway, had the original ideas not been overthrown, the Euro Area would also have had a central government. Unfortunately neoliberalism became popular in the 1980s and this led to the Maastricht Treaty which forgot the original intentions of the founders.

The Treaty’s opening also has this important line:

RECOGNISING that the removal of existing obstacles calls for concerted action in order to guarantee steady expansion, balanced trade and fair competition

I should mention however that the Euro Area has this thing called the Macroeconomic Imbalance Procedure which tries to address the issue and even thinks of current account surpluses in the balance of payments as an imbalance, but it is still far away from doing anything about it, such as a coordinated fiscal policy expansion.

Do US Trade Deficits Result In “Net Profits” For The US?

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It’s frequently claimed that the US 🇺🇸 has trade deficits but since the US dollar has not collapsed, the ones saying that the US does not have a balance of payments constraint are all wrong.

Now there are several errors in this line of reasoning but going straight to the point: the balance-of-payments constraint is first a constraint on output. There’s a deflationary bias in the US output because of the imbalance in trade.

This article is written in response to a blog post Cumulative U.S. Trade Deficits Resulting in Net Profits for the U.S. (and Net Losses for China) at the blog macroblog by the Federal Reserve Bank of Atlanta. The article says:

The United States has run trade deficits for decades (1976 is the last year with a recorded surplus). To illustrate this, chart 1 depicts the cumulative U.S. trade deficit since 1980, which now surpasses $10 trillion. As a result, a drastic deterioration in the U.S. net foreign asset position—the difference between the amount of foreign assets owned by U.S. residents and the amount of U.S. assets owned by foreigners—has occurred. That is, as Americans borrow from the rest of the world to finance the recurring trade deficits, the national net worth goes deeply into the red. Not long ago, many commentators predicted that as a result of this increasing U.S. foreign debt, the U.S. dollar was set to collapse, which would trigger a stampede away from U.S. assets. Of course, this has not happened.

The wording of this itself is problematic. First some definitions:

Here’s from the IMF’s Balance of Payments And International Investment Position Manual (BPM6), pg 9:

The balance of payments is a statistical statement that summarizes transactions between residents and nonresidents during a period. It consists of the goods and services account, the primary income account, the secondary income account, the capital account, and the financial account. Under the double-entry accounting system that underlies the balance of payments, each transaction is recorded as consisting of two entries and the sum of the credit entries and the sum of the debit entries is the same.

What the US has is a positive balance in the secondary income account (more credits than debits) despite running large deficits in the primary account and despite having a large negative net international position. But “net loss” or “net profit” is bad wording to start with. Also the net international investment position itself is not “national net worth” because the latter includes non-financial assets owned by resident economic units and hence doesn’t make an appearance in the international investment position.

Now coming back to the point on output – If the US economy were to run under full capacity at all times with the current account deficit widening and the net international investment position deteriorating relative to gdp without limit, it can then be claimed that the US doesn’t have this problem and the economists worrying about US trade got it all wrong. But that is far from the case. Not only is the US economy not running under full capacity, but so much output has been lost since the beginning of the crisis starting in 2007.

Having an imbalance in trade means that output multipliers aren’t as high as it would have been the case otherwise. So the government expenditure multiplier and private expenditure multiplier are inversely related to the propensity to import and would have been higher if the propensity to import were less.

Usually economists talk about either trade or the financial aspect (i.e. either the current account or the financial account of the balance of payments) but not both together in a single unified framework. Most of the conclusions reached are due to lack of analysis which treat both of them simultaneously. Stock flow consistent models are an exception but other models are so messed up even for the closed-economy that it’s difficult in those models to make progress.

The fact that the US secondary income is in the US’ favour has led economists to draw any conclusion they want from their analysis. Let’s touch one aspect – the tipping point.

The tipping point

Let’s say you have assets worth $100 and earning at 6% annually (such as interest or dividend), and liabilities of $110 paying at 5%. So even though your liabilities are higher than assets, your income on assets ($6) is higher than what you pay on your liabilities ($5.5). So far, so good, so what? While this is not a bad situation, this is unlikely to remain the case forever. For example if your assets stay the same whereas liabilities rise to $130, then the net income is against your favour. You are earning $6 per year but paying $6.5.

The point of the above example is that even though the US earns more on assets held abroad than what it pays nonresident economic units on their financial assets, this process cannot continue forever. Sooner or later, the difference between the assets and liabilities (because of continuous trade deficits) will be so high that the secondary income in the current account in the balance of payments will be negative. So estimating the tipping point is estimating when this will happen.

Surely, if the US runs at full capacity and hence higher trade deficits because of higher national income and income effects on imports, the US will hit the tipping point sooner. At that point nobody can obfuscate the debate by saying that the secondary income balance in the current account of the balance of payments is positive. The international investment position will deteriorate at a much faster rate.

Of course reaching the tipping point itself is not apocalypse. Some countries do have a negative balance in the secondary income account of their balance of payments. The situation can continue as long as markets allow it to go on. When the busts, it will create a problem but nobody has a theory yet on when exactly some busts, although we’ve made progress on identifying unsustainable processes.

The point of the above analysis is that none of the arguments trying to claim directly or implicitly that “current account deficits do not matter” are erroneous.

No, the dollar won’t collapse but the US economy will run from full capacity to keep debts in check. Such as so much lost output in the last 9 years or so. To summarize, there are at least two scenarios here which are either confused or conflated or both by economic commentators:

  1. The US economy running closer to full capacity but with international investment position deteriorating fast and a threat to the US economy and the currency.
  2. Status-quo, where there’s deflationary bias to the US economy and hence consequences to output, employment and income for the bottom of the population but no immediate threat to the international investment position (although deteriorating) and in which there’s no dollar collapse.

The empiric of scenario 2 above cannot be used to argue that scenario 1 is benign because these two are different states of the world.

The solution is another scenario, a scenario 3 in which output is raises by fiscal expansion but the US government also works to address its balance of payments problems. For example, China’s strategy of exports is quite damaging to the US economy and it is important that the US establishment addresses this instead of just saying “it does matter” or that market mechanism will do the trick.

Milton Friedman On Free Trade

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I always like watching Milton Friedman, not because I like him but for something totally opposite. It helps in knowing what the exact position of economists is. Milton Friedman has been hugely influential on how economists think. Almost everyone is just rambling what Friedman said, so why not listen to their master?

This is a lecture given in 1978 on free trade.

Milton Friedman Lecture On Free Trade

click the picture to watch the video on YouTube

A claim made by Friedman in the video is that market mechanisms work to resolve balance of payments problems. “Balance of payments is not a problem”, says Friedman. Of course that’s all wrong but economists continue to believe in such things.

Another claim made by Friedman is that protectionism is because few industries lobby for it. While that is certainly true, how about “free trade” itself? Producers with market share in international markets influence their governments to push for free trade internationally. Why didn’t he talk of those things?

Output At Home And Abroad

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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.

  1. Capital flows cause exchange rates to move. With floating exchange rates, the exchange rate is the price which clears the supply and demand for assets of currencies. Note, in a correct model of exchange rates, supply and demand for all assets should be included not just “money” or “currency”. Exchange rate movement impact prices of goods and services. Since imports and exports depend on prices of goods and services (among other things), capital flows impact trade balance. It’s of course important to keep in mind producers’ own pricing behaviour: If the Japanese Yen appreciates by 30% against the US dollar, it’s not necessary that Japanese producers will raise prices of their goods in the U.S. market by 30%. They might raise the price only by 10%. But this is a digression, the important point being that capital flows cause changes in prices of imports and exports and hence the trade balance.
  2. Long term interest rates are both due to expectations of short term interest rates and portfolio preference for assets such as government bonds with long maturities. Long term Interest rates have an effect on aggregate demand which has an effect on output and income and hence imports.
  3. Capital flows can cause asset price booms, such as a stock market boom and via the wealth effect, cause changes in output and income and hence imports.
  4. There’s a further complication. Suppose there’s a large capital inflow into equities. This can cause switch of resident holders of equities (issued by resident economic units) into newly produced houses. This has an effect on aggregate demand and output and hence income and imports. This mechanism is slightly different from the wealth effect in point 3. It’s more a flow effect. Also in my opinion, it’s not easy to model this because one has to keep in mind gross capital outflows in balance of payments as well.
  5. Purchase of new houses by non-residents: Depending on regulations in the land, foreigners can directly purchase houses – such as a vacation house in Greece or to speculate on house prices such as in London. There can even be foreign investment funds which can speculate by buying houses and commercial property. This has the effect on aggregate demand and output and income and hence imports.
  6. Securitization allows banks to package loans on their balance sheet and sell it to investors. This allows banks to reduce risks and because of this they can make more loans which they may not have made without securitization. More lending means higher aggregate demand and output and income and affects imports.
  7. Direct investment: Direct investment is a more complicated example. Direct investment can raise output by various means, such as causing rising business domestically, employing people. They not only have an effect on the trade balance because of their international nature but also because their profits affect balance of payments. Also one has to be careful: sometimes direct investment is confused with the I in the identity: G − T + CAB = S − I. Needless to say, this is confusing the different meanings of “investment”.
  8. Large capital outflows can cause a large depreciation of the currency and impact a nation’s fiscal policy. If there are large gross outflows, a government may be forced to deflate domestic demand and output to reduce imports. The flip-side is that large capital flows can keep a bubble from busting for long.

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).