Tag Archives: balance of payments

“Free Trade Doctrine, In Practice, Is A More Subtle Form Of Mercantilism”

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Dani Rodrik has written a very interesting article The New Mercantilist Challenge for Project Syndicate. 

Perhaps it is the main aim of this blog to argue how the sacred tenet of free trade is devastating to the world as a whole and why a sustainable resolution of a crisis can only be achieved by new international agreements on how to trade with one another combined with coordinated demand management policies with an expansionary bias.

Joan Robinson was one of the fiercest critics of free trade. A good appreciation of her work is by Robert Blecker in the book Joan Robinson’s Economics (2005)

Joan Robinson's Economics

Blecker says:

Robinson’s critique of free trade had several dimensions, including her opposition to the comparative static methodology usually employed to “prove” the existence of gains from trade, as well as her scathing criticism of the actual practice of trade policy by nations proclaiming their fealty to free trade while seeking mercantilist advantages over their neighbors. Robinson also thought that international trade relations were far more conflictive than they were usually portrayed by free traders

[emphasis: mine]

In her 1977 essay What Are The Questions? (which is full of quotable quotes) Robinson says:

A surplus of exports is advantageous, first of all, in connection with the short-period problem of effective demand. A surplus of value of exports over value of imports represents “foreign investment.” An increase in it has an employment and multiplier effect. Any increase in activity at home is liable to increase imports so that a boost to income and employment from an increase in the flow of home investment is partly offset by a reduction in foreign investment. A boost due to increasing exports or production of home substitutes for imports (when there is sufficient slack in the economy) does not reduce home investment, but creates conditions favorable to raising it. Thus, an export surplus is a more powerful stimulus to income than home investment.

In the beggar-my-neighbor scramble for trade during the great slump, every country was desparately trying to export its own unemployment. Every country had to join in, for any one that attempted to maintain employment without protecting its balance of trade (through tariffs, subsidies, depreciation, etc.) would have been beggared by the others.

From a long-run point of view, export-led growth is the basis of success. A country that has a competitive advantage in industrial production can maintain a high level of home investment, without fear of being checked by a balance-of-payments crisis. Capital accumulation and technical improvements then progressively enhance its competitive advantage. Employment is high and real-wage rates rising so that “labor trouble” is kept at bay. Its financial position is strong. If it prefers an extra rise of home consumption to acquiring foreign assets, it can allow its exchange rate to appreciate and turn the terms of trade in its own favor. In all these respects, a country in a weak competitive position suffers the corresponding disadvantages.

When Ricardo set out the case against protection, he was supporting British economic interests. Free trade ruined Portuguese industry. Free trade for others is in the interests of the strongest competitor in world markets, and a sufficiently strong competitor has no need for protection at home. Free trade doctrine, in practice, is a more subtle form of Mercantilism. When Britain was the workshop of the world, universal free trade suited her interests. When (with the aid of protection) rival industries developed in Germany and the United States, she was still able to preserve free trade for her own exports in the Empire. The historical tradition of attachment to free trade doctrine is so strong in England that even now, in her weakness, the idea of protectionism is considered shocking.

[emphasis: mine]

Joan Robinson - What Are The Questions

Joan Robinson (1981)
What Are The Questions? And Other Essays

Random Tidbits On National Accounts And Keynesian Models Of Income And Expenditure

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I came across this article (via a Tweet from Stephen Kinsella): Accounting As The Master Metaphor Of Economics by Arjo Klamer and Donald McCloskey which discusses how the framework of national accounts has been pushed to the background in economic analysis over the years.

It is a nice read – although boring in a few places. I found this reference to John Hicks’ 1942 book The Social Framework: An Introduction To Economics in the above article and managed to get a copy – although a used one but with almost no usage. As described in the Klamer-McCloskey’s article, Hicks’ textbook really goes into details of national accounts and he seems to have had a great intuition of how it all works.

John Hicks - The Social Framework

Hicks’s book gives a nice introduction to how important national accounts are in understanding and describing the production process and economic cycles.

Here is a scan of two pages on the balance of payments – the topic I like the most.

John Hicks Balance Of Payments

(click to enlarge)

Hicks understood how weak balance of payments can cause troubles. Of course, it took the genius of Nicholas Kaldor to realize the supreme importance of balance of payments in the determination of national income and expenditure. Leaving that aside, the text has nice ideas and discussions on how stocks and flows feed into one another.

John Hicks is famous for an entirely different reason – the IS/LM model. Later he accepted it was a huge mistake, but put it mildly: “… as time as gone on, I have myself become dissatisfied with it”. But economists still keep using it and keep erring.

Also, Hicks was to soon abandon/forget his own social accounting approach as per Klamer-McCloskey’s article. Perhaps, not really.

In an extremely important paper, Wynne Godley said:

To come down to it, the present paper claims to have made, so far as I know for the first time, a rigorous synthesis of the theory of credit and money creation with that of income determination in the (Cambridge) Keynesian tradition. My belief is that nothing the paper contains would have been surprising or new to, say, Kaldor, Hicks, Joan Robinson or Kahn.

John Hicks also had another nice book called A Market Theory Of Money written in 1989. Here is a great insight (also the view of Kaldor) from Page 11, Chapter 1 named “Supply And Demand?” on how to create a dynamic Keynesian theory of determination of national income and expenditure:

… The traditional view that market price is, at least in some way, determined by an equation of demand and supply had now to be given up. If demand and supply are interpreted, as had formerly seemed to be sufficient, as flow demands and supplies coming from outsiders, it is no longer true that there is any tendency over any particular period, for them to be equalized: a difference between them, if it were not too large, could be matched by a change in stocks. It is of course true that if no distinction is made between demand from stockholders and demand from outside the market, demand and supply in that inclusive sense  must be equal. But that equation is vacuous. It cannot be used to determine price, in Walras’ or Marshall’s manner. For what matters to the stockholder is the stock that he is holding: the increment in that stock, during a period is the difference between what is held at the end and what was held at the beginning, and the beginning stock is carried over from the past. So the demand-supply equation can only be used in a recursive manner, to determine a sequence (It is a difference or a differential equation); it cannot be used directly to determine price, as Walras and Marshall had used it.

I came across a reference in the book (The Social Framework) to a paper by James Meade and Richard Stone on concepts on national accounts: The Construction Of Tables Of National Income, Expenditure, Savings And Investment written in 1941. It has the following interesting table:

James Meade & Richard Stone - Sectoral Balances

which is the now famous sectoral balances identity! Incidentally, it also includes Kalecki’s profit equation. In the above “Foreign Investment” shouldn’t be confused with Foreign Direct Investment flows in the financial account of the balance of payments. The authors define it as:

… equal to income generated by receipts from abroad less current expenditure abroad.

So can we call the profit equation SMK equation? 🙂

James Meade and Richard Stone were pioneers of national accounts. Incidentally, James Meade wrote a famous textbook on balance of payments.

Of course the way this is presented doesn’t make the connection between the financial account and current accounts. The sectoral balances was usually written by Wynne Godley as:

NAFA = PSBR + BP

where NAFA is the net accumulation of financial assets of the private sector, PSBR is the net public sector borrowing requirement, and BP is the current account balance of international payments. More on this connection below.

How it is to be derived in a stock-flow consistent framwork of Godley/Lavoie? If you click on this search Transactions Flow Matrix, you will find some blog posts on the background. First, we construct a flow matrix like this:

Simplified National Income Matrix

The last line is essentially Kalecki’s profit equation.

The above construction however raises an important question. Godley and Lavoie’s textbook (Chapter 2) quotes a famous 1949 article of Morris Copeland on this:

When total purchases of our national product increase, where does the money come from to finance them? When purchases of our national product decline, what becomes of the money that is not spent?

Copeland’s work was highly successful and established the flow of funds accounts of the United States in 1952.

Here is a republished version of the article (via Google Books):

click to preview on Google Books’ site

Incidentally, Copeland was motivated to prove the quantity theory of money wrong when he did this work! Also Godley/Lavoie point out that John Dawson (the editor of the above book) says:

the acceptance of…flow-of-funds accounting by academic economists has been an uphill battle because its implications run counter to a number of doctrines deeply embedded in the minds of economists.

in an article from the chapter The Conceptual Relation Of Flow-Of-Funds Accounts To The SNA of the same book.

Over time, the system of national accounts (with its first version in 1947) has used some of the concepts of flow of funds accounting and now the framework is much more wider than usual textbook guides of national accounts. The flow of funds still retains importance because it has information which the system of national accounts such as (2008 SNA) doesn’t handle.

Here’s the UN website for the historical versions of the system of national accounts.

How does one look at this in a stock-flow coherent framework? Simple, we need a full transactions flow matrix – which not only includes income/expenditure flows but also financial flows. The following is how it looks like for a simple model:

Transactions Flow Matrix 3

(Click to zoom)

Of course, identities themselves shouldn’t be looked at as models. One needs a fully coherent accounting model of the economy based on behavioural assumptions and “closures”. See this essay Keynesian theorising during hard times: stock-flow consistent models as an unexplored ‘frontier’ of Keynesian macroeconomics Camb. J. Econ. (July 2006) 30(4): 541-565 by Claudio Dos Santos and also Wynne Godley and Marc Lavoie’s book Monetary Economics. As Dos Santos quotes Lance Taylor in the article:

Formally, prescribing a closure boils down to stating which variables are endogenous or exogenous in an equation system largely based upon macroeconomic accounting identities, and figuring out how they influence one another.

Money Supposedly Became Fiat And Hence Balance Of Payments Does Not Matter Kind Of Argument

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So Karl Whelan wrote another article on TARGET2 claiming once more that a loss of TARGET2 claims of the Bundesbank does not matter at all to Germany. He has a new paper as well. Earlier he was arguing there was no loss at all.

His argument roughly is that since there is no longer trade settlement in gold, money is thence fiat and the loss does not matter.

Closed economy monetary economics is confusing enough for most monetary economists but when matters of open economy are discussed, it is a Herculean task for them to make sense of simple things. Some economists are better but end up making a mess.

First there is this story of “fiat money”. Supposedly after 1973 – when the Smithsonian Agreement broke down – money or currencies became fiat according to many theories. I guess this is generally the notion made popular by Austrian economists as far as I can tell and (is the root of all evil in this story). But this is strange. If “fiat money” has any meaning to it, money was equally fiat before – either during the Bretton Woods system or in any monetary institutional setups before that. So the US Dollar was as fiat as in 1920 as in 2012. There’s no meaning to saying that currencies became fiat suddenly.

Of course, in the Bretton Woods system, nations’ governments were required to redeem official foreign balances either in gold (till 1968), SDRs (after 1968) or in the currency of the member making the request (if any). In addition, there was a system of market convertibility in addition to official convertibility. In addition, the US volunteered to convert official foreign balances to gold till 1971.

So one could say that international trade was settled in gold. However, since money is credit, international trade would also settle by borrowing from foreigners – not just the official sector borrowing but other resident sectors borrowing from foreigners. The proper way to understand this is to study how balance of payments accounting is done and it was no different now than what it used to be.

A nation which runs a trade deficit need not lose gold reserves because the current account deficit could be financed via the financial account. If there is a problem in inflow, changes in interest rates by the central bank would attract funds from foreign financial centers.

More generally as always, it is income changes which works to bring imbalances back to balance. Sometimes things get out of hand, leading to a loss of gold reserves and the need for international financial help for exceptional financing of the balance of payments. But even in the supposedly new fiat world, things can get out of hand and require exceptional financing transactions.

Before Bretton Woods, nations had less formal agreements and typically the central bank and/or the government would promise to convert currency notes into gold at the request of the holder and not just official balances. It was thought that this made currencies acceptable and that the central bank should not issue more currency notes than the amount of gold they held. This story however, has no empirical support. It was however thought that the amount of currency notes is some multiple of the amount of gold and perhaps this is the origin of the story of the multiplier. But this is a troublesome story and there is some sort of view that money is exogenous in such monetary setups but endogenous otherwise – which makes no sense at all. Money is always credit-led and demand-determined and hence endogenous.

[To be more complete, some nations do not have a legal tender of their own and use other currencies as per law]

Now, economists argued that in the era of fixed exchange rates, an outflow of gold would lead to an automatic contraction of the money stock – the underlying theory being that of the money multiplier. This is presented as the Mundell-Fleming approach. Wages would reduce and this will lead to more competitiveness in international markets and bring the trade imbalance back into balance. This didn’t work because the whole notion was based on ideas of the money multiplier and notions such as that. (In addition it ignores the crucial aspect of non-price competitiveness).

So Emperor’s New Clothes – economists figured that floating exchanges would do the trick. Even a great economist such as Nicholas Kaldor believed so (while he was warning about troubles with the Bretton Woods system in the 1960s) but he was the first to point out that it doesn’t do the trick – soon in the 1970s.

More troublesome is the notion that if a nation is indebteded to foreigners in the domestic currency, it doesn’t owe foreigners anything and that this debt is just technical. The reason given is that nations are relieved to convert balances of foreign governments and/or central banks in the new era (the ones floating their exchange rates). But this is highly mistaken. While it is untrue (official convertibility still exists), it ignores the more important concept of market convertibility. The “reason” is dubious. It is true that it doesn’t cost the central bank anything if banks ask for currency notes to satisfy the demand for their customers, it doesn’t mean much. The private sector net wealth and aggregate demand is affected by net government expenditures and precisely when the nation has a balance of payments crisis, does the government have less power. It however is useful to have the government to make expenditures and take other emergency actions to handle a crisis in the external sector (with the exception of governments in a monetary union and nations which have “dollarization”). Debt denominated in domestic currency is useful for another reason. Assuming foreigners do not repatriate funds abroad when the currency is depreciating, it prevents a revaluation loss on liabilities. Indebtednesss in foreign currency on the other hand, leads to revaluation losses – implying more is needed from export receipts to prevent the debt from getting out of hand.

The fact that in any monetary setup nations face a balance of payments constraint has led nations to grow via success in international trade. Those who understood this trick early gained market and their success led to more success. This in turn puts a handicap on the rest of the world. The ‘mercantalist’ nations while didn’t believe the invisible hand (according to Keynes) nevertheless gain tremendously from the present system of free trade. As long as free trade is maintained, it is advantageous to nations to have strong external positions – in trade and in claims held on foreigners.

Now to the paper of Karl Whelan.

For Whelan, the external assets of a nation – including the claims of the government on non-residents – does not matter at all.

When considering the loss of the Bundesbank’s TARGET2 claim, it is important to distinguish between implications that matter and those that don’t.  Most of the commentary on this issue has focused on implications for the Bundesbank itself and the need for a hugely costly recapitalisation of the central bank.  For example, Burda (2012) argues that “Germany has now become a hostage to the monetary union, since a unilateral exit would imply a new central bank with negative equity.” However, there are a number of reasons why the capital position of the central bank is something of a red herring when considering a break-up scenario.

The first reason for this is that despite the common belief that central banks need to have assets that exceed their notional liabilities, there is no concrete basis for this position. Systems like the Gold Standard required a central bank to “back” the money in circulation with a specific asset but there is no such requirement when operating a modern fiat currency.  A central bank operating a fiat currency could have assets that fall below the value of the money it has issued – the balance sheet could show it to be “insolvent” – without having an impact on the value of the currency in circulation. A fiat currency’s value, its real purchasing power, is determined by how much money has been supplied and the factors influencing money demand, not by the central bank’s stock of assets. As discussed in the attached box, close examination reveals little merit to the various arguments that are put forward for the idea that a central bank must have positive capital to achieve its goals.

The second reason the focus on central bank capital is a red herring is that, even if it is decided after a break-up that Germany must recapitalise the Bundesbank, rather than being hugely costly, this recapitalisation would have no impact on either the net asset position of the German state or its budget deficit.  Let’s assume the German government recapitalises the Bundesbank by providing it with an interest-bearing government bond.  While the government’s gross debt will increase, the government bond becomes an asset of the Bundesbank, so the total public net debt does not change.

Similarly, suppose the new debt provides interest payments of €3.9 billion (equal to the annual interest that would be generated by the September 2012 level of Bundesbank net Intra-Eurosystem claims). This payment would raise the profits of the Bundesbank by this amount, thus raising the amount the Bundesbank can return to the German government by the same amount, resulting in no change in the budget deficit.

So the issue facing Germany in case of a loss of its Intra-Eurosystem claims is not the insolvency of the Bundesbank or the costs associated with recapitalising it.  The real issue is simply that the Bundesbank had a large asset and this asset will have disappeared. Still, despite the eye-popping level of the Bundesbank’s TARGET2 claim, the disappearance of the net income from the Intra-Eurosystem claims would have a very modest impact on the annual German budget. At an interest rate of 0.75 percent, the yield of €3.9 billion on the net Intra-Eurosystem claims of €516 billion as of the end of September represents only 0.15 percent of German GDP. Rather than a huge potential loss keeping Germany hostage within the Eurozone, I suspect this is a loss than many Germans would shrug off as perhaps being smaller than the likely costs associated with the sovereign bailout funds aimed at saving the euro.

Although Whelan accepts there is a loss (although he wasn’t earlier), there is hodge-podge here in the whole write-up. Whether there is gold involved in settlement of international debt or if the government promises to convert currency notes into gold (to keep its currency acceptable and which is just an illusion in any case) is an entirely irrelevant issue. The potential of a loss of huge amounts (given that a panic can lead to further losses for the German public sector – to see how see this post) is dreadful to Germany. The seigniorage calculation is hardly useful. It is like telling someone that a $1m loss doesn’t matter because it only earns $2,500 per year – given current interest rates. His point that there is “no change in the budget deficit” if Bundesbank’s foreign assets get replaced by German government debt has a simple calculation mistake – in one case the public sector is receiving interest income from abroad and in the other it isn’t.

(Apologies for misspelling Whelan earlier in some places in earlier version)

Not A Balance-Of-Payments Crisis?

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Here’s a new piece by Randall Wray on Economonitor claiming current accounts do not matter (once again!) and didn’t have much of a role on the Euro Area crisis. Part of his arguments are the same as those who participated in public debates 1991 (most, not all) and claimed the balance-of-payments doesn’t matter.

Perhaps he should revise his study of sectoral balances.

Before I consider his analysis, let me remind you why current account deficits matter. A current account deficit is the deficit between the income and expenditure of all resident units of an economy and because it is a deficit, it needs to be financed. Cumulative current account deficits lead to a rise in the net indebtedness of a nation (i.e., consolidated net debt of all resident sectors of an economy) and cannot keep rising forever relative to output. This is because a deficit in the current account is equal to the net borrowing of the nation which has to be financed and secondly, the debt built up needs to be refinanced again and again.

Here’s via Eurostat

It is clear from the chart that nations with high negative NIIP (and hence high net indebtedness) were/are the ones in trouble.

The accounting identity which connects the NIIP to CAB is:

Δ NIIP = CAB + Revaluations

Most of the times, revaluations have less of a role in explaining the NIIP. Of course one can always come up with exceptions – such as for the United States with huge revaluations due to outward FDI and Ireland. It should however be noted that Ireland also had high current account deficits.

Here is data from the IMF on the current account balances:

From this you can see “Germany is not Greece”, “Netherlands is not Spain”, “Finland is not Cyprus” and so on and also the relation of CAB to NIIP.

Let me turn now to what Wray has to say:

Yesterday one presenter at this conference provided a lot of interesting data on cross border lending by European banks, most of which consisted of lending to fellow EMU members. He showed a strong correlation between cross border lending and cross border trade. Hence, posited a link between flows of finance and flows of goods and services. So far, so good. He also accepted a comment from the audience that correlation doesn’t prove causation, and that flows of finance are orders of magnitude larger than trade in goods and services—in other words, most of the financial churning has nothing to do with “real” production.

So atleast Wray accepts there is a correlation of some kind. For causation, see the arguments presented at the beginning of this post.

I won’t rehash that argument. Balances do balance, after all. For every current account deficit there’s a capital account surplus. It seems to me that the claim that the EMU suffers from “imbalances” is on even shakier ground. After all, they all use the same currency, so there’s no chance that an “imbalance” will lead to a run on the currency and to exchange rate depreciation (a usual fear following on from a current account deficit).

This argument was made by neoclassical economists around late 80s and early 90s when Europe was planning to form a monetary union. See this post Martin Wolf Pays A Generous Tribute To Anthony Thirlwall. Wray misses the point that a balance-of-payments crisis also leads to a deflationary spiral and that even though there is no exchange rate collapse, there is deflation in the Euro Area – exactly as predicted by those economists who thought the notion “current account deficits do not matter” was precisely wrong in the early 1990s.

Then Wray goes on to suggest that banks creating a boom and bust in Germany would have looked different:

Yes. But in what sense is that an “imbalance”? Look at it this way. What if instead of running up real estate prices in the sunny south—so that Brits and northern Europeans could enjoy vacation homes—the German banks had instead fueled a real estate bubble in Berlin? What if they had eliminated all underwriting standards and lent until the cows come home on the prospect that Berlin house prices would rise at an accelerating pace? Speculators from across the world would buy a piece of the bubble on the prospect that they’d reap the gains and sell-out at the peak. Construction activity would boom, workers could demand higher wages and would increase consumption, and Germany would have experienced higher price inflation than the rest of Euroland.

In the hypothetical case of Wray where German banks lend the non-financial sectors till the “cows come home”, domestic demand would have risen sharply (which he himself suggests) and this would have had the adverse effect on the balance of payments. Germany would have started running current account deficits because imports are dependent on domestic demand. Germany would have suffered similar fate but in the end it would have depended on how fast the domestic demand rose.

Wray should be careful in doing sectoral balances.

Bad bank behavior can boom or bust an economy—with or without current account deficits. And that’s pretty much what happened in Spain and Ireland (and also in Iceland).

Wray would have sounded right if he had given examples of nations having current account surpluses but from IMF’s table above it can be seen that both Spain and Ireland had huge current account deficits.

What about Iceland?

The data is from 2004-2011 and you can see that in 2008, Iceland had a current account deficit of 28.4%.

Wray then compares the Euro Area to the United States:

In Euroland, all use the same euro currency, and clearing is accomplished among the central banks and through the ECB (that is where Target 2 comes in). It works about as smoothly as the US system. But here’s the difference: the ECB “district banks” are national central banks. It is thus easier to keep mental tabs on the “imbalances” by member states in the EMU than in the USA.

Yes keeping mental tabs on imbalances (and not “imbalances”) can have its effect, but Wray crucially misses the point that in the United States, there is an automatic mechanism of compensating for trade imbalances via fiscal transfers. This acts via lower total taxes paid by regions facing slowdown caused by trade imbalances (not to be confused with lesser taxes paid due to reduced tax rates if any). A rise in public expenditure (not necessarily discretionary but resulting from government guarantees made beforehand) also helps.

Wray however quotes Mosler but he misses the point as well since it talks of directed government spending as opposed to a built in automatic mechanism which (the latter) prevents a crisis at this scale/type from happening.

Generally speaking, Wray seems to suggest that the crisis happened because the private sector credit-led boom went bust and this has nothing to do with current account imbalances. While it is true that the private sector credit-led boom ended in a bust and caused a crisis, what Wray misses is that the current account deficits contributed to exacerbating the crisis because nations in trouble built up huge indebtedness to the rest of the world and had troubles to refinance their debts. If all sectors of an economy have a consolidated net indebtedness position to the rest of the world, they will have issues borrowing and refinancing since – as a matter of accounting – foreigners have to attracted. Foreigners were unwilling because of doubts and also because there was/is a crisis in the world economy, they changed their portfolio preferences – making the whole issue of financing even more difficult.

A Digression On TARGET2

It can be argued that since the TARGET2 mechanism has a stabilizer of some sort – that since the Eurosystem TARGET2 claims arising due to capital flight from the “periphery” is an accommodative item in the balance-of-payments, current account deficits shouldn’t have been an issue.

The error in this argument is that while it is true that capital flight is automatically financed by the resultant Eurosystem TARGET2 claims and that this is helpful, it depends on the hidden assumption that banks have unlimited/uncollaterilized overdrafts at their home central banks. We have seen in various scenarios – such as with procedures such as the Emergency Liquidity Assistance (ELA) – that banks in the “periphery” can either run out of sufficient collateral needed to borrow from their home NCB or have chances to run out of collateral. They hence need to attract funds from abroad. The nation as a whole is dependent on foreigners. Current account deficits are not self-financing.

U.S. Net Indebtedness Above $5T Now

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The BEA reported yesterday that the U.S. Net International Investment Position at the end of 2011 was minus $4,030.3bn. The large change compared to the end of 2010 (where it was -$2,473.6bn) was due to large revaluations of assets and liabilities in addition to the current account deficit. See the BEA blog on this.

For IIP, Foreign Direct Investments are measured at “current costs”. When evaluated at market prices, the net international investment position at the end of 2011 would have been minus $4,812.4bn. The NIIP also includes official gold holdings and if this is excluded, the net indebtedness is greater than $5T.

The following is the NIIP as a percent of GDP at market prices.

There are several reasons this by itself hasn’t worked against the U.S. The U.S. dollar is the reserve currency of the world* and secondly direct investments make huge returns for the U.S. (It should still be noted that the current account deficits bleed demand in the U.S. at a massive scale). Direct investment abroad at the end of 2011 was about $4.5tn and foreign direct investment by nonresidents in the United States $3.5T.

U.S. International Investment Position

(click to enlarge)

The direct investment abroad makes a huge killing for the U.S. as can be seen from the balance of payments. In 2011, direct investment receipts was around $480bn and direct investment payments only $159bn.

U.S. Current Balance of Payments

(click to enlarge)

 *non-direct investment income is already against the United States’ favour though.

The Accommodating Item In The Swiss Balance Of Payments

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Michael Sankowski has a post titled Swiss Franc: Trade Of The Year in which – as the title suggests – he points to getting the timing right of the depreciation of the Swiss Franc against the Euro as one trade which can have a huge payoff. His argument  is: assuming that the Euro will survive and financial markets gain confidence in the Euro, change in investor portfolio preference into Euro-denominated assets will depreciate the Franc.

Which is fine – as this New York Times article Necessity, Not Inclination, Nudges Europeans Closer Fiscally And Politically argues, it seems Germany is being forced to cede some control to the European Parliament which may act as a central government of the Euro Area (hopefully democratically elected!).

In September 2011, after the SNB found it frustrating that in spite of its intervention in the foreign exchange markets, it could not prevent an appreciation of the Franc. So it decided to say this:

Notice that it is not really a peg but a floor on EURCHF. Here’s a chart of EURCHF (via FT)

Daniel Neilson wrote a post about this on INET but his scenario is slightly different on what may actually happen to the Euro Area.

At any rate, he has an nice study of the effects of the flows on the balance sheets of the SNB and Swiss banks.

… the SNB is facilitating the world’s portfolio reallocation out of EUR and into CHF. Even fixed at 1.20 francs per euro, funds have been fleeing the euro area as the crisis heats up again. The SNB’s policy means that any net flow results not in price adjustment, but in fluctuations in the size of its own balance sheet.

Neilson also makes an interesting observation that there is a similarity of this to TARGET2 in which Bundesbank acquires claims on foreign central banks as funds flow into Germany. He points out however that the SNB has a choice of which asset it can purchase!

Since I am more a balance of payments kind of person, I tend to see this in that language. When a financial institution or a household – either a resident or a nonresident – liquidates Euro denominated assets for its purpose, it will purchase Francs for Euros. The dealer – a bank – which makes this conversion will credit the seller’s bank account and and will try to get rid of the excess Euro denominated deposits at its correspondent bank (which it obtained). If the SNB does not intervene, this sale of EUR by Swiss banks will appreciate the Franc and hence the SNB has to accommodate this and buy EUR. It can then purchase high-quality Euro denominated assets such as German government bills (?). The Swiss bank who made the conversion will have both its assets and liabilities denominated in Franc increase (assets: SNB settlement balances, liabilities: deposits). With the short term Franc interest rate at zero – the SNB needn’t do a “sterilization” operation.

How does this look in the financial account of the balance of payments? If the initial inflow was 100, then:

We can say that the item reserve assets of the SNB is the accommodating item in the balance of payments.

Toward A Higher European Integration?

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In an article today Europe Mulls Major Step Towards “Fiscal Union”, Reuters reports that Angela Merkel is pushing for a “giant leap forward”:

After falling short with her “fiscal compact” on budget discipline, German Chancellor Angela Merkel is pressing for much more ambitious measures, including a central authority to manage euro area finances, and major new powers for the European Commission, European Parliament and European Court of Justice.

She is also seeking a coordinated European approach to reforming labor markets, social security systems and tax policies, German officials say.

Until states agree to these steps and the unprecedented loss of sovereignty they involve, the officials say Berlin will refuse to consider other initiatives like joint euro zone bonds or a “banking union” with cross-border deposit guarantees – steps Berlin says could only come in a second wave.

“Kaldorians” jumped to highlight the serious defects in the European plan for integration when officials were working on the Maastricht Treaty. One of the implicit assumption on which the dogma of “free trade” is pushed is that current account deficits do not matter. The government’s task is to only make markets free in this view. The Euro Area was formed with the highly incorrect notion (among various others) that nations can simply solve their “balance of payments problem” by getting rid of it altogether.

I was reading this article by Ken Coutts and Wynne Godley from 1990 [1] where the authors point to different kinds of arguments put forward by others to defend this position (“current account deficits do not matter” provided markets are made free).

There appear to be six different lines of argument to the effect that the current account deficit can be ignored …

… (v) A different kind of argument makes a comparison between a nation with an external deficit and a relatively poor region within a nation. It is pointed out that there is no balance of payments problem for Scotland or for Northern Ireland and from this it is concluded that as soon as Britain joins a European monetary union its balance of payments ‘problem’ will disappear permanently …

… The argument (v) that a region within a country cannot have a balance of payments ‘problem’ ignores the fact that if a region imports more than it exports its trade deficit is automatically paid for by fiscal transfers.[footnote: Strictly speaking, the fiscal transfers will always exactly compensate for any trade deficit only after allowing for the acquisition of financial assets by the private sector as implied by the ‘New Cambridge’ identity (exports less imports equals net government outlays plus the ‘trade’ deficit). The identity says, of course, nothing whatever about the level of real income and output which trading performance will have generated]. The point may be illustrated by considering an extreme case where a region consumes tradables but cannot produce them at all. In this case there will be a trade deficit exactly equal to imports of tradables, but the flow of government expenditure and net transfers will provide a minimum level of income support and keep life of a kind going without any borrowing at all taking place. If an uncompetitive region were not in receipt of fiscal inflows, its inhabitants would have no alternative but to emigrate or starve. This example illustrates that merely by sharing a common currency with another area, a region or country does not automatically dispose of its balance of payments problems since its prosperity still depends on how successfully it can compete in trade with other areas. The Delors Report itself correctly observes that a monetary union transforms a weakness in the ability to compete successfully from being a balance of payments problem into a regional problem to which there is only likely to be a solution by using the instruments of regional policy.

The movement toward more integration by giving higher powers to the European Parliament was also suggested by Wynne Godley and Marc Lavoie in 2007 [2]:

… Alternatively, the present structure of the European Union would need to be modified, giving far more spending and taxing power to the European Union Parliament, transforming it into a bona fide federal government that would be able to engage into substantial equalisation payments which would automatically transfer fiscal resources from the more successful to the less successful members of the euro zone. In this manner, the eurozone would be provided with a mechanism that would reduce the present bias towards downward fiscal adjustments of the deficit countries.

References

  1. Prosperity and Foreign Trade in the 1990s: Britain’s Strategic Problem, Oxf Rev Econ Policy (1990) 6 (3):82-92. Link
  2. A Simple Model Of Three Economies With Two Currencies, Camb. J. Econ. (2007) 31 (1): 1-23. Link

Cyprus Seeking Bailout

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According to a Wall Street Journal article from yesterday Cyprus Seen Close to a Request for Bailout, Cyprus (2011 GDP: €18bn approximately) is set to become the fourth Euro Area nation to seek a bailout after Greece, Ireland and Portugal. According to the WSJ:

Late last year, the country negotiated a €2.5 billion ($3.1 billion) bilateral loan from Russia. Now, Cyprus is in talks with China for another bilateral loan, of an undisclosed amount, that looks unlikely to materialize in time.

Had to go into trouble considering that economists have been realizing that the Euro Area problems is an internal balance of payments crisis.

The closest proxy for a nation’s net indebtedness is the net international investment position (as opposed to “external debt” which excludes equity held by nonresidents). Here’s the chart as of 2011: the NIIP is at the end of 2011 and the GDP is the gross domestic product for the whole year.

(click to enlarge)

Note: Greece’s NIIP improved in 2011 (from minus 100% of gdp) due to large revaluation losses suffered by foreigners as Greece financial markets fell in 2011.

The financial markets is now nervous about Spain and Slovakia’s next in the line if the graph is to be believed and it’s external position is in dangerous territory also – at minus 64%.

According to Wynne Godley, anything between 20-40% of net foreign indebtedness can be highly dangerous. Of course his models also show that there is nothing intrinsically stopping such imbalances from continuing and can go on as long as foreigners do not mind but something has to give in – such as slower growth to prevent the imbalances from continuing before foreigners start minding or a crash.

At this point, Slovakia doesn’t seem to be in trouble with its generic 10-year government bond yield at 3.645% – with its public debt at 43.3% of gdp at the end of 2011 according to Eurostat. This of course means that the domestic private sector is a net debtor (i.e., its financial assets is lesser than its liabilities). A more detailed analysis is required on how internal imbalances will play out and spill over to the external sector. Here’s from Statistical Appendix of the “Alert Mechanism Report”.

(click to enlarge)

Moving on to something different:

Heteredox Economics In Playboy!

Via Twitter:

click to view the tweet on Twitter

John Cochrane of Chicago calls heteredox economists “kooks” and claims he and his colleagues use rigorous models!

Mosler And His Moslerisms

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A few readers/commenters of my blog brought attention to a video of Warren Mosler where he claims that “there is no such thing as a capital flight” – presumably for a nation with a “sovereign currency” with the implication that a Euro Area nations can simply leave the Euro and adopt their original currency without a fear of capital flight post the event.

(Why have capital controls then, if that’s the case?)

Link @22:15

This claim can be easily dismissed by simple balance of payments analysis.

For this I use the IMF’s Balance of Payments Manual (BPM6). First lets look at the format of the BPM6’s numerical example.

The example is below:

(click to enlarge)

Roughly Mosler’s argument is that if a foreigner sells assets denominated in the domestic currency, some other foreigner would need to buy it.

He gives a Bretton-Woods anti-analogy where – presumably – an official foreign creditor can demand gold for conversion and repatriate it home by ship. And that since official convertibility to gold is suspended, there is no capital flight according to this mini-story.

To see there is capital flight, one needs to look at the foreign exchange market microstructure. By the way, the Neochartalists erroneously tend to treat banks as brokers (as opposed to dealers) in the foreign exchange markets. Let us say a foreigner – perhaps a financial institution – with “portfolio investment” in the country in question liquidates assets in the domestic currency and exchanges it at a domestic bank (domestic with respect to the country we are discussing). This “order flow” leaves the bank with a short position in foreign currency which it will try to eliminate. This will lead to a cascading effect because the foreign dealer it may want to offload its position will react itself and hence a series of transactions in the fx markets – leading to a depreciation of the currency.

It may happen that the currency depreciation may bring in an order flow in the opposite direction – thereby leading to a quasi-equilibrium. However if the general expectations is such that the currency may depreciate further then it is hard. If such expectations are formed, there may be even more capital ouflow!

It is precisely here that the central bank may intervene and sell foreign reserves – thereby helping the dealers (both domestic and foreign to offload their undesired positions). So recently there was news of intervention by the Reserve Bank of India in the fx markets. (minor technicality: the reduction of domestic banks’ settlement balances due to the settlement of central bank fx sales will lead to a “fine tuning reverse operation” by the central bank)

So how does the whole thing look in the balance of payments? The answer is very simple: assuming foreigners sold 100 units of assets – minus 100 due to liquidation of domestic assets and minus 100 due to sale of reserve assets.

So that’s capital flight.

And … like that … it’s gone!

Balance Of Payments: Part 2 – Double Versus Quadruple Entry Bookkeeping

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Some time back I had started with the first part of a series of posts on this topic: see Balance Of Payments: Part 1. From the same post, here’s from the Australian Bureau of Statistics’ manual Balance of Payments and International Investment Position, Australia, Concepts, Sources and Methods, 1998

(click to enlarge)

So we have the current account, the financial and the international investment position at the beginning and end of each accounting period. In addition we have, revaluations on assets and liabilities. These arise due to change in the value of assets (such as rise in stock markets) and due to movement of the exchange rate or both.

Also, textbooks use a slightly different language than official statistics and manuals. Textbooks simply use the phrase capital account when they mean the financial account.

I aim to go into each of this and the behaviour of institutions who are involved in the whole process and how it leads to changes in assets and liabilities of all sectors and the consequences. We will see how endemic current account deficits act as a hemorrhage in the circular flow of national income as Wynne Godley would put it and decides the fate of nations as Anthony Thirlwall may have it.

To really appreciate, one needs to have a strong methodology for studying this. One way is to use G&L’s transactions flow matrix but it can get complicated in case of two nations. Needless to say, from a modeling perspective, it is more useful than the usual way of studying balance of payments. However, for appreciating G&L methodology one needs to first understand the usual way of studying this.

Double Entry Versus Quadruple Entry Bookkeeping

In contrast to national accounts, Balance of Payments is based on double entry bookkeeping. 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.

In contrast, national accounts as per SNA2008 or G&L’s way of doing it uses quadruple entry bookkeeping who point out in their book Monetary Economics that:

… Copeland pointed out that, ‘because moneyflows transactions involve two transactors, the social accounting approach to moneyflows rests not on a double-entry system but on a quadruple-entry system’. Knowing that each of the columns and each of the rows must sum to zero at all times, it follows that any alteration in one cell of the matrix must imply a modification to at least three other cells. The transactions matrix used here provides us with an exhibit which allows to report each financial flow both as an inflow to a given sector and as an outflow to the other sector involved in the transaction.

G&L point out that even Hyman Minsky was aware of this. Here’s from the article The Essential Characteristics of Post-Keynesian Economics (page 20):

The structure of an economic model that is relevant for a capitalist economy needs to include the interrelated balance sheets and income statements of the units of the economy. The principle of double entry book keeping, where financial assets are liabilities on another balance sheet and where every entry on   balance sheet has a dual in another entry on the same balance sheet, means that every transaction in assets requires four entries.

The System of National Accounts 2008 (2008 SNA) says (page 21):

In principle, the recording of the consequences of an action as it affects all units and all sectors is based on a principle of quadruple entry accounting, because most transactions involve two institutional units. Each transaction of this type must be recorded twice by each of the two transactors involved. For example, a social benefit in cash paid by a government unit to a household is recorded in the accounts of government as a use under the relevant type of transfers and a negative acquisition of assets under currency and deposits; in the accounts of the household sector, it is recorded as a resource under transfers and an acquisition of assets under currency and deposits. The principle of quadruple entry accounting applies even when the detailed from-whom-to-whom relations between sectors are not shown in the accounts. Correctly recording the four transactions involved ensures full consistency in the accounts.

Simple example: your and my favourite: loans make deposits. The following is a transaction where a household has borrowed some funds from the banking sector:

 

Introduction To Current Transactions

I mentioned that in recording transactions between residents and nonresidents and presenting it as balance of payments, national accountants use double entry bookkeeping (as opposed to quadruple), so any transaction in the current account necessarily involves another entry in the financial account (ignoring barter and accidental cancellations). However, the opposite is not the case: a transaction on the financial account will lead to another entry in the financial account and not directly in the current account. A purchase of US equities by a UK resident cannot be said to cause or increase the US current account deficit.

One example: if you are are US citizen travelling to the UK and have pay for coffee at the London airport by paying in Federal Reserve notes, it will give rise to an entry in the current account (credit from the perspective of the UK balance of payments) and a debit (increase in assets of UK residents: change in currency notes). This is just transaction among thousands and the question is how is all this to be recorded and more importantly (later) what does it tell us.

Here’s how a standard balance of payments table looks like (note: this does not include international investment position)

(source: UK Pink Book 2011; click to enlarge)

We will go over details in the next post in this series. For now let us see how this looks for the example presented earlier: A US traveller pays $10 for coffee at the London Heathrow airport with Federal Reserve currency notes. Assuming the current exchange rate, the following (double) entries need to be included in the UK balance of payments:

 

£ CreditsDebits
Current Account
Goods and Services6.328
Financial Account
Bank Deposits, Foreign Currency Assets6.328

 

 

This is a simple example – hardly needing so much background and information but in the next post in this series, we will look at complicated examples where intuitions can easily go wrong. If the above were the only transaction between UK and US residents in the accounting period (quarter/year), this will also change the US indebtedness to the UK by £6.328 or $10 and this will be shown in the international investment positions of the UK and the US. If the exchange rate had moved from the start of the period, revaluations would need to be done to record the closing stocks of assets and liabilities.