Due to the continuing capital flight out of Spain, the TARGET2 liabilities of Banco de España increased in April and averaged €284.5bn in the month. The flow equivalent in the balance-of-payments language may be called the accommodating item.
If a government (outside monetary unions) can make a draft at the central bank, why do rating agencies rate governments’ creditworthiness?
In this post, I will attempt to describe the dynamics of defaults and restructurings by going through some monetary economics of open economies.
Carmen Reinhart and Kenneth Rogoff wrote a book in 2009 titled This Time Is Different: Eight Centuries Of Financial Folly or simply This Time Is Different arguing that governments do indeed default – both in debt denominated in the domestic and foreign currencies. They blame the public debt and the government for the public debt – hence giving the innuendo that governments across the planet should attempt to cut public debt by tight fiscal policies. This is an illegitimate conclusion – on which I will say more below.
At another extreme are the Chartalists who argue that the government cannot “run out of money” and hence fiscal policy has no monetary constraints. Sometimes they qualify this statement by saying that the currency they are discussing are “sovereign currencies”. Now, there are various definitions of what a sovereign currency is but it is frequently pointed out by them that nations who have seen restructuring of government debt did not have a “sovereign currency” – because the currency is either pegged or fixed or it is the case that the government had a lot of debt in foreign currency which presumably allows defaults/restructuring of government debt in the domestic currency as well. The motivation behind this is Milton Friedman’s idea that nations should freely float their currencies in international markets and that markets will clear and that the State intervention in the currency markets can only make things worse. Hence Reinhart/Rogoff don’t prove them wrong – according to them – since the situations are supposedly different.
We will see that while there is some truth to it, the notion of a “sovereign currency” is highly misleading. Such intuitions are coincident with the incorrect notion that indebtedness to foreigners (in domestic currency) is just a technical liability and there’s nothing more to that!
Here’s S&P’s article on the methodology it uses to assign ratings on governments: Standard & Poor’s – Sovereign Government Rating And Methodology. One can see the importance it gives to the external sector. However, S&P does not provide a mechanism on how a government will finally end up defaulting. The purpose of this post is to look into this.
Before this let us make a connection between the public debt and the net indebtedness of a nation. Most people in the planet confuse the two. The former is the debt of the government whereas the latter is the (net) indebtedness of the nation as a whole. This is the net international investment position (adjusting for traditional settlement assets such as gold) with the sign reversed. This can be obtained by consolidating all the sectors of an economy and the consolidation involves (for example) netting of the assets of the domestic private sector held abroad and also its gross indebtedness to the rest of the world.
So one can think of two extremes:
Japan – with a high public debt of about 195% of gdp (includes just the central government debt), while being a net creditor of the world. It’s NIIP is about 50% of gdp (data source: MoF, Japan)
Australia – with a low public debt of 18% of gdp and NIIP of minus 59% of gdp.
So in the case of Japan, while the government is a huge debtor, the nation as a whole is a creditor, whereas in the case of Australia, it is the opposite. So the rating agencies get it wrong or opposite!
Let us first assume a closed economy. The greatest starting point in analyzing economies is the sectoral balances approach. For a closed economy it is:
NAFA = DEF
where NAFA is the Net Accumulation of Financial Assets of the private sector and DEF is the government’s budget deficit. If the private sector wants to accumulate a lot of financial assets, and the government wants to run the economy near full employment, the public debt will be higher, the higher the propensity to save, for example. (This is not as straightforward as presented here but can be shown in a simple stock-flow consistent model). So unlike what neoclassical economists think, the level of public debt is somewhat irrelevant. Neither does the government has too much trouble in financing its debt because the public debt is the mirror image of the private sector net financial asset position.
Now let us take the case of an open economy. The sectoral balances identity now is
NAFA = DEF + CAB
A deficit in the current account implies an increase in the net indebtedness to foreigners. Unless the markets miraculously clear with the exchange rate adjusting to bring the CAB in balance, a deficit in the current account implies the nation as a whole has to attract foreigners to finance this deficit i.e., via a lower NAFA or higher DEF. In the long run, the private sector is accumulating financial assets (or has small positive NAFA) and the whole of the current account balance is reflected in the public sector balance.
So the debate fixed vs floating doesn’t help too much. A relaxation of fiscal policy may spill over into higher imports with the public debt and the net indebtedness to foreigners keeps rising forever to gdp. Hence nations typically have to curb growth to bring the current account into balance.
This is theory. So let’s look at an open economy mechanism of an event of default by the government as a story.
In the following, I will use the phrase “pure float” instead of the dubious terminology “sovereign currency”.
Here’s the simplest model:
In the above, a nation with its currency on a pure float and with zero official sector liabilities in foreign currencies has a somewhat weak external position in 2012. Now, according to some of the Neochartalist arguments this nation can’t default on its government debt. However this is a wrong conclusion as the scenario above hightlights. In the scenario constructed, the balance of payments position weakens over the years (and I have mentioned that roughly in 2020 it weakens). In 2022, foreigners are no longer willing to finance the debt. This may be due to a capital flight or due to the inability of the banking system to maintain a low net open position in foreign currency. The depreciation of the domestic currency isn’t sufficient to clear the fx markets and the official sector (either the central bank or the government’s treasury) necessarily has to intervene in the foreign exchange markets by issuing debt denominated in foreign currency. The government is then acting as the borrower of the last resort and the objective is to use the proceeds to partially have more foreign exchange reserves and/or to sell the foreign currency proceeds from the debt issuance to clear the fx markets. The government is then left with a net liability position in the foreign currency. Soon the external situation worsens to the point requiring official foreign help – such as from the IMF – which promises to help and requires a restructuring of the debt both in domestic and foreign currencies.
Free marketers have a blind belief in the markets and the theories are built on the assumption that markets always clear. The recent crisis has highlighted that this isn’t the case. Even for the case of Australia – whose currency can be considered closed to being pure float – has had issues in the external sector and the Reserve Bank of Australia had to borrow in US dollars from the Federal Reserve (via swap lines) to help Australian banks meet their foreign currency funding needs during the crisis.
Of course the above is not typical but to prevent the external vulnerability to go out of control, governments keep domestic demand low and a lot of times, they over-do this.
The point of the exercise is to prove that it is not meaningless to think of nations becoming bankrupt in whichever situation one can think of and it doesn’t help to laugh at the rating agencies and make fun of them – possibly with the exception for the case of Japan. Statements such as “government with a sovereign currency cannot become bankrupt” are simply misleading. In the above, the Chartalists would argue that the currency was not sovereign and they were not wrong about the default but the currency was sovereign in their own definition in 2012!
Here are some comments on some nations.
Japan: As mentioned above, Japan is a net creditor of the rest of the world and partially as a consequence of that, most of the Japanese government’s debt is held internally. The rating agencies are aware of this but in spite of this continue to make comments on the creditworthiness of the Japanese government. It is possible that residents may transfer funds abroad for unknown reasons (which the raters for some reason suspect) but it may require just a minor interest rate hike to prevent this from happening. Japan has a relatively strong external situation and hence has no issues in financing its government debt.
Canada: Nick Rowe of WCI mentioned to me on his blog that worrying about the balance of payments constraint is like “beating a dead horse” – citing the example of Canada which has floated its currency and it seems has no trouble with its external sector. But this ignores other things in the formulation of the problem. Canada is an advanced nation and an external situation which is not weak. However, a growth of the nation much faster than the rest of the world will lead to a worsening of the external situation. To some extent the nation’s external situation has been the result of its relatively better competitiveness of exporters compared to its propensity to import and a demand situation which either as a conscious attempt of demand management of the government or by pure fluke has helped its external situation remain non-vulnerable.
United States: The US dollar is the reserve currency of the world and slowly over time, the United States has turned from being a creditor of the rest of the world to becoming the world’s largest debtor nation. (Again not due to its public debt but because of its net indebtedness to foreigners). The US external sector is a great imbalance and any attempt to get out of the recession by fiscal policy alone will worsen its external situation leading to a crash at some point. S&P is right! So to come out of the depressed state, the nation has to complement fiscal expansion with improvement of the external situation such as by (and not restricted to) asking trading partners to not revalue their currencies. Still for some reasons bloggers at the “New Economic Perspectives” think that
… Bernanke also knows that the US has infinite ability to finance these fiscal components, that there is no solvency issue and that the policy rate and both ends of the yield curve are under the direct control of the Fed.
Back to This Time Is Different. While Reinhart and Rogoff’s analysis of government debt may be useful, their conclusions can be destructive for the world as a whole. The domestic private sector of a nation needs continuous injection from outside so that it can run surpluses in general and tightening of fiscal policies will lead to a depression. Global imbalances is crucial in understanding the nature of this crisis (and not public debt alone) and even coordinated attempts to reflate economies may provide only a temporary relief. Since failure in international trade restricts the growth of nations and their attempts to reach full employment, what the world needs is an entirely different way to run the economies under managed trade with fiscal expansion. Ideas of “free trade” such as that outlined here by Alan Blinder simply help some classes of society at the expense of others because it relies on the “market mechanism” which has failed over and over again.
This brings me to “sovereignty”. As argued, the concept “sovereign currency” is almost vacuous (except highlighting the problems of the Euro Area) but sovereignty as argued by Wynne Godley in his great 1992 article Maastricht And All That and by Anthony Thirlwall in the same year on FT (my post on it here Martin Wolf Pays A Generous Tribute To Anthony Thirlwall) definitely have great importance. Some of Thirwall’s concepts of economic sovereignty in the article were: the ability to protect and encourage strategic industries, the possibility of designing systems of managed trade to even out payments imbalances, the ability to protect against certain countries with persistent surpluses, differential taxes which discriminate in favour of the tradeable goods sector.
Martin Wolf has just written an article on FT: Why the Bundesbank is wrong questioning the arguments made by Jens Weidmann, president of the Bundesbank. (This speech: Rebalancing Europe).
This chart is interesting:
(click to enlarge)
Wolf says:
Arguably, the crucial step is to agree on the nature of the illness. On this, progress is now being achieved, at least among economists. It is widely accepted that the balance of payments is fundamental to any understanding of the present crisis. Indeed, the balance of payments may matter more in the eurozone than among economies not bound together in a currency union.
I am not sure how widely accepted or understood this is, but it’s exactly right!
(Also never mind the reference to Werner Sinn in the next line in the original article – although Sinn still had a point in spite of his rather painful analysis)
Unable to make a draft at the central bank, governments are left with less means of protecting themselves in case of failures. Hence nations in a currency union are more directly dependent on the external sector.
Then on Weidmann:
Alas, these remarks confuse productivity with competitiveness. Yet these are distinct: the US, for example, is more productive, but less competitive, than China. External competitiveness is relative. Moreover, at the global level, the adjustment must also be shared. Mr Weidmann knows this. As he says, “of course, surplus countries will eventually be affected as deficit countries adjust”. The question is by what mechanism.
[emphasis: mine]
Martin Wolf knows how economies as a whole work roughly and he has been emphasizing that the solution to the world’s problems lie with the creditor nations. Also, in 2004 he said that America is in a comfortable path to ruin!
So here’s an unsuccessful attempt to prove Martin Wolf doesn’t “get it” from Bill Mitchell: So near but so far … from comprehension. This was a critique of an article written by Martin Wolf where he showed that the creditor status of Japan is hugely helpful to its recovery in spite of having a huge public debt . . . Martin Wolf’s right in spite of Mitchell’s assertion that he is wrong 🙂
In a recent paper, Bradford DeLong and Lawrence Summers suggest that a fiscal expansion can be useful to bring an economy from a depressed state (!). The rough idea being that a relaxation of fiscal policy leads to a higher output and the increase in economic activity leads to a stabilization of public debt/gdp ratio.
This condition is valid as long as (in the authors’ terminology):
(click to enlarge)
The interesting thing about this is that the authors suggest that even if r > g, it is possible for the public debt/gdp to remain sustainable under certain conditions.
I won’t have more to say on this because it uses a standard one-period analysis but the fact that some mainstream authors seem to understand the fiscal policy dynamics better is encouraging.
Arguing that their “… conclusions conflict with those of the “new consensus,” which holds that a correct setting of interest rates is the necessary and sufficient condition for achieving noninflationary growth at full employment, leaving fiscal policy rather in the air.”, they also derive a result for a closed economy:
It is usually asserted that, for the debt dynamics to remain sustainable, the real rate of interest must be lower than the real rate of growth of the economy for a given ratio of primary budget surplus to gdp. If this condition is not fulfilled, the government needs to pursue a discretionary policy that aims to achieve a sufficiently large primary surplus. We can easily demonstrate that there are no such requirements in a fully consistent stock-flow model such as ours.
The G&L style of modeling is extremely useful because it gives great attention to stocks and flows so that no errors creep in. The result is surprising the first time one hears this because it goes against intuition. This can be seen by thinking of the interest payments of the government as income for the domestic private sector!
So no conditions such as r < g!
Open Economy Debt Dynamics
For open economies, G&L are also able to construct select scenarios where a debtor nation can be indebted to the rest of the world without the nation’s debt (which is different from public debt) increasing relative to gdp forever. (Of course by no means proving/implying it for all possible scenarios).
where d is “external debt” and pb is the primary balance of the current account balance. (The expressions are relative to gdp)
Suppose the government and the central bank want to restrict external debt to 50% of gdp – with the view that foreigners may consider moving above it as unsustainable. Assume growth is 3.5% and effective interest rate paid on liabilities to foreigners is 1%. Then the tolerable primary deficit of current account balance is 1.25%. This is calculated by setting the left hand side to zero and just plugging the formulas. (See below)
Please note, a higher growth will worsen the external balance so it is not a good argument that growth can lead to a lower debt/gdp ratio.
To summarize, intuitions for a closed economy and the open economy can appear contradictory.
Standard Analysis
I have seen many economists including Post Keynesians (not G&L) take the above equation and interpret it rather differently. So assuming sustainability, a constant primary balance pb implies the debt sustains at
or simply,
A continuous time formulation leads to an equality sign. The above is derived by assuming the debt sustains at d and shuffling the terms in the first equation.
Note: the above is valid only if there a stabilization. Else, in the case where g < r, the above expression gives a negative answer for a negative primary balance – but that is because the derivation assumed sustainability and cannot be used when debt/gdp keeps rising.
This is also written sometimes as
by expanding the denominator of the previous expression using the Taylor Theorem from Mathematics.
This raises a curiosity – how come in the G&L case for the closed economy did the debt sustain even when g > r? That’s because it was a dynamic stock-flow consistent model as opposed to the artificial assumption of a constant deficit used in standard analysis such as the third equation above.
Nonetheless the above analysis shows that for a constant deficit (though artificial), debt sustains as per the equation (assuming growth and the rate of interest paid are constant as well!)
Back to Open Economies
Moving to the open economy case, where debt and deficit denote the external debt and the current account deficit, the above shows that if the primary deficit is restricted somehow to say 5% of gdp and the differential between growth and interest rate is 2%, the external debt sustains at 250% of gdp.
This should be seen as a restriction. Instead some/many Post Keynesians just state it is sustainable. A higher growth rate will increase the deficit (current account) and the debt-dynamics can make the whole process unsustainable. So one needs to model how fiscal policy itself affects the current account deficit rather than keeping it a constant relative to gdp.
This is the reason many nations find themselves troubled by the external sector.
This can be seen for the case of the United States. A huge relaxation of fiscal policy will bring back the current account deficit to 6% of gdp (and rising) and put the world on an unsustainable path. What the United States needs to do is ask its trading partners to expand domestic demand by fiscal expansion and achieve higher growth so that it itself can achieve a higher growth rate due to the extra space created for fiscal policy.
More generally, we need a concerted action!
For a related analysis see Dean Baker’s recent analysis on the trade deficit being America’s fundamental imbalance: The Iron Grip of Accounting Identities
Summary
There is no condition such as if r <g, debt is sustainable. Debt can keep rising relative to gdp simply because deficit keeps rising.
The condition r > g can be useful in studying certain circumstances for analysis.
My last post was on U.S. net income payments from abroad and how it continues to be in the favour of the United States. The late Wynne Godley had been analyzing this since 1994. In an article titled U.S. Trade Deficits: The Recovery’s Dark Side?, written with William Milberg, he had a section called “Foreign indebtedness and the foreign income paradox” where he said:
So far, the practical consequences of the United States having become “the world’s largest debtor” have not been all that significant… But it would be an error to suppose that, because the net return on net assets has been negligible in the recent past, the same thing will be true in the future…
… Why did the net foreign income flow remain positive for so long after 1988? In order to understand this apparent paradox, it is essential to disaggregate stocks of assets and liabilities and their associated flows, and to distinguish (in particular) between financial assets and direct investments… The reason that net foreign income remained positive for so long can now be understood (at least up to a point) by making a comparison of the flows shown in Figure 3 with the stocks shown in Figure 2. The net inflow that arises from direct investment has been roughly equal to the net outflow on financial assets in recent years, even though the stock of financial liabilities has been about five times as large as the market value of net foreign investments. In other words, the rate of return on net direct investments far exceeded the rate on net financial liabilities
Figure 2 referred to is below:
and Figure 3:
which is what I redrew with updated data in my previous post. But as we saw the net income payments from abroad continues to be positive (!!) even till date but the reason is similar. Foreign direct investment in the United States has risen to $2.8T at the end of 2011 as per Federal Reserve’s Z.1 Flow of Funds while U.S direct investment abroad rose to $4.8T – significantly higher (even as a percent of GDP) than in the mid-90s.
The net direct investment has seen huge returns (both via income and holding gains) and so this killing has brought in good fortunes for the United States. Of course with the whole current account of balance of payments in deficit, the external sector bleeds the circular flow of national income in the United States and contributes to weak demand there.
So a current account deficit is bad for the United States but financing this deficit has been easy for the United States given that the US Dollar is the reserve currency of the world. Why do nations require reserve assets? The late Joseph Gold of the IMF gave a nice description in his book Legal and Institutional Aspects of the International Monetary System: Selected Essays:
click to view on Google Books
What makes the US dollar the reserve currency of the world is difficult to argue. However it cannot be taken for granted that the United States may enjoy this exorbitant privilege given that the Sterling was once the darling of the financial markets and central banks.
Their argument is similar – direct investments have made huge returns for the domestic private sector of the United States and gives a good account of the external sector. Here’s a graph of the United States’ net international investment position using data reported by the Federal Reserve’s Z.1 Flow of Funds Accounts as well as the BEA’s International Investment Position:
Why the difference is a topic for another post. I don’t know it yet. Gourinchas and Rey have some answers. The Federal Reserve’s data is till 2011 end and quarterly (and seasonally adjusted) while BEA data is yearly and available till 2010.
So, from the graph above, the United States became a net debtor of the world around 1986. The indebtedness has been rising mainly due to the huge current account deficits the nation manages to run and is partly offset by “holding gains”.
Here’s a graph of the current account deficit plotted with other “financial balances” (since they are related by an identity)
By the way, the U.S. was a creditor of the world when the Bretton Woods system of fixed exchange rates collapsed. Some authors describe this collapse by saying that money has become fiat since 1971 – whatever that means!
Gourinchas and Rey point out – correctly in my opinion:
The previous discussion points to a possible instability, even in an international monetary system that lacks a formal anchor. The relevant reference here is Triffin’s prescient work on the fundamental instability of the Bretton Woods system (see Triffin 1960). Triffin saw that in a world where the fluctuations in gold supply were dictated by the vagaries of discoveries in South Africa or the destabilizing schemes of Soviet Russia, but in any case unable to grow with world demand for liquidity, the demand for the dollar was bound to eventually exceed the gold reserves of the Federal Reserve. This left the door open for a run on the dollar. Interestingly, the current situation can be seen in a similar light: in a world where the United States can supply the international currency at will and invests it in illiquid assets, it still faces a confidence risk. There could be a run on the dollar not because investors would fear an abandonment of the gold parity, as in the 1970s, but because they would fear a plunge in the dollar exchange rate. In other words, Triffin’s analysis does not have to rely on the gold-dollar parity to be relevant. Gold or not, the specter of the Triffin dilemma may still be haunting us!
Gourinchas and Rey’s arguments depend on estimating a tipping point – the point where the net income payments from abroad turn negative. This of course depends on various assumptions but let us look at it.
The gross assets of the United States held abroad and liabilities to foreigners keep changing as the nation is able to increase its liabilities and use it to make direct investments abroad. The reserve currency status has provided the nation with this privilege as central banks around the world are willing to hold dollar-denominated assets. The positive return (as well as revaluation gains from the depreciation of the dollar – when it depreciates) helps reduce the net indebtedness but the current account deficit contributes to increasing it.
The following is the graph of gross assets and liabilities – using the Federal Reserve’s Z.1 Flow of Funds Accounts data and also BEA’s data for the ratio:
So assuming assets held abroad A make a return rA and liabilities L to foreigners lead to payments at an effective interest rate rL income payments from abroad will turn negative whenever
rA · A − rL · L < 0
So A and L are changing due to the current account deficits and revaluation gains on assets and liabilities. Meanwhile, the effective interest rates are themselves changing in time because of various things such as short term interest rates set by the central banks, market conditions, state of the economy etc. Also, if the private sector of the United States makes more direct investments abroad, this will contribute to increase rA (if successful) and the process can go on with net income payments from abroad staying positive for longer. The tipping point is defined by Gourinchas and Rey as the ratio L/A beyond which the the net income payments turn negative. According to their analysis (based purely on historical data), this is 1.30.
If the net income payments from abroad turns negative, international financial markets and central banks may start suspecting the future of the exorbitant privilege according to the authors. Of course, it may be the case that even if it turns negative, the United States’ creditors don’t mind – this has been the case of Australia. The following is from the page 18 of the Australian Bureau of Statistics release Balance of Payments and International Investment Position, Australia, Dec 2011 and in their terminology – which is the same as the IMF’s – it is called “net primary income”)
(Australia’s Q4 2011 GDP was around A$369bn for comparison) and the above graph is quarterly.
So, to conclude the process can continue as long as foreigners do not mind. It shouldn’t be forgotten however that Australian banks had funding issues during the financial crisis and the RBA used its line of credit at the Federal Reserve via fx swaps to prevent a run on Australian banks and it is difficult to design policy without keeping in mind the possibility of walking into uncharted territory.
Once net primary income turns negative, the process can quickly run into unsustainable territory due to the magic of compounding of interest unless the currency depreciates in the favour of the nation helping exports. Else demand has to be curtailed to prevent an explosion but this hurts employment. Other policy options include promotion of exports and asking trading partners to increase domestic demand by fiscal expansion.
The world economy has grown over the last so many years with the United States acting as the importer of the last resort. However, the U.S. current account deficit acts to bleed the circular flow of national income and weakens demand in the States. The nation still grew because of a huge lending boom.
Today, the U.S. Bureau of Economic Analysis came out with the Q4 report on the U.S. International Transactions. According to the release,
The U.S. current-account deficit—the combined balances on trade in goods and services, income, and net unilateral current transfers—increased to $124.1 billion (preliminary) in the fourth quarter of 2011, from $107.6 billion (revised) in the third quarter. Most of the increase in the current account deficit was due to a decrease in the surplus on income and an increase in the deficit on goods and services.
So the current account balance also consists of “income payments from abroad” – a bit of wrong phrasing because all items are income/expenditure flows. The net income payments from abroad continues to surprise analysts because in spite of the net indebtedness position of the United States, this continues to be positive and in recent times has increased! (although it fell the last quarter). Many hold the belief that the United States has lower interest rates and this is the consequence of that. While it is true that interest rates outside the U.S. are in general higher, and there is some truth to the above argument, it gives one the wrong impression that it will always be the case that net income from abroad will always be positive.
The following graph shows that this intuition is misleading. Most of the contribution to the net income is due to direct investments abroad which has made a killing for the private sector and the reverse – direct investment receipts for foreigners has made next to nothing. The remaining – income from financial assets held abroad less interest/dividend paid to foreigners’ holding of U.S. financial assets is already negative!
The red line has reduced in recent times due to lower interest rates in the U.S. presumably. But the more the U.S. continues to run large current account deficits, the deeper the red line will grow – pulling the black line to zero and into the negative territory.
The net income payments from abroad is more a result of the huge killing the U.S. domestic private sector has made abroad than because of lower interest rates. For example, excluding FDI, the data from BEA suggests that the “effective interest rate” on U.S. liabilities was 1.42% in 2010, while that on U.S assets held abroad is 1.65%. This differential will not be sufficient to keep the income payments to foreigners bounded. I used the 2010 data because the International Investment Position is available only till 2010 and the one for end of 2011 will be released only mid-2012.
To understand this, consider the case when the U.S net indebtedness grows to something about 100% of GDP due to the continuous current account deficits – if market forces allow the whole process to go on(!). This is an involved analysis involving some growth assumptions and the fiscal stance in the U.S. and the rest of the world. For example, people frequently forget that a higher growth in the U.S. will also bring in higher current account deficits. But it can easily be shown that the red and the black lines above grow into a negative territory if the United States wants to quickly achieve full employment by fiscal policy alone.
Of course the above graph shows that there is a lot fiscal expansion can achieve in the medium term for the United States.
These numbers look “small” and can lead one into believing that “all is well”. And this is another mistaken view. For example if there is a drastic relaxation of fiscal policy by the U.S. government, the current account deficit will soon hit 6-8% of GDP which may require further relaxation of fiscal expansion to compensate the leakage of demand due to the current account deficit and with income payments turning negative due to higher indebtedness, this will turn into an unsustainable path because the current account deficits and net indebtedness will keep increasing relative to GDP. This will need interest rate hikes to attract foreigners but turns the whole process unsustainable unless one believes in the foreign exchange market doing the trick. Also currently the interest rates are low because the Federal Reserve has kept them artificially low and foreigners do not mind holding U.S. dollar assets at this rate. As William Dudley says interest rates will be raised at some point by the Federal Reserve and this will increase payments to foreigners. See this post William Dudley On U.S. Sectoral Balances
Of course, this is not the only scenario and there’s a lot fiscal policy can achieve in the medium term but it is important to keep in mind that something needs to be done with the external sector to bring the external sector in balance to achieve full employment.
This is the first part of a series of posts I intend to write on the “rest of the world” accounts in National Accounts. This blog is about looking at economies from the point of view of National Accounts, Cambridge Keynesianism and Horizontalism. While various descriptions of balance of payments exist, most of them simply end up making money exogeneity assumption somewhere in the description!
In my view a careful description of balance of payments offers great insights on how economies work and what money really is. It is impossible to understand the success and failures of nations without understanding the external sector.
A description in terms of stocks and flows is the most appropriate for macroeconomics. Fortunately, national accountants have a good systematic approach to this.
Consider the following transaction: a government (or a corporation) raises funds in the international markets. The buyers can be residents as well as non-residents. The currency of the new issuance can be domestic as well as foreign. Does this by itself increase the net indebtedness of the nation as a whole?
The answer is No, and can be a bit surprising to the reader because the answer is the same whether the currency is domestic or foreign. The trick in the question is that an issuance of debt increases the assets and liabilities of the issuer!
(Note: the question was about the transaction, not on what happens after this)
Gross assets and liabilities vis-à-vis the rest of the world can be a bit more complicated and we need a more systematic analysis.
Consider another transaction. A government is redeeming a 7% bond with a notional of 1bn with semi-annual coupons. How much does the net indebtedness of the country change? Assuming that all the lenders are in the rest of the world sector, the net indebtedness changes by 35m. Does not matter if the currency is domestic or not. Why 35m? Because the semi-annual coupon has to be paid on redemption and the coupons are interest payments and this is recorded in the current account and this increases the net indebtedness. The principal payment cancels out the earlier liability – the bonds.
So between the start and the end of the period, foreigners earned 35m and this increased the net indebtedness of the nation who paid the interest. Of course there are other transactions which can cancel this out.
In another scenario, if all the bond holders were residents, the net indebtedness does not change – whether the bonds were in domestic currency or not.
The above was about financing. What about imports and exports? Exports provide income to a nation or a region as a whole and imports are opposite. If a nation is a net importer (more appropriately running a current account deficit), this means its expenditure is higher than income. When expenditure is higher than income, this has to be financed and this is via net borrowing.
There is one important point worth stressing. Many people – including many economists (most?) – treat liabilities to foreigners in domestic currency as not really a liability at all – at least the government’s liabilities. The reason provided is that while usually the government is forbidden from making an overdraft at the central bank or have limited powers in using central bank credit, it can end up making a higher use of it than the limits allowed – in extreme conditions. This in my opinion, is a silly intuition.
While it is true that the governments of most nations (with exceptions such as the Euro Area governments) can make a draft at the central bank and this offers the government protection to tide over extreme emergencies, the government has to directly or indirectly finance the current account deficits and this can prove unsustainable. Despite this there is an advantage in having indebtedness to foreigners in the domestic currency because:
An indebtedness to foreigners in domestic currency prevents revaluation losses on the debt if foreigners continue holding the debt and if the currency depreciates against foreign currencies. If the debt is denominated in a foreign currency and if it depreciates, more income needs to be earned from abroad to service the principal and interest payments.
The discussion can be confusing because of the relative ease with which the United States has managed till now to finance its current account deficits because the US dollar is the reserve currency of the world and continues to do so and the holders are willing to accept liabilities of resident sectors of the United States, especially the government’s at low interest rates/yields.
James Tobin, who has provided the best description of the meaning of government deficits and debt said this in an article “Agenda For International Coordination Of Macroeconomic Policies” (Google Books link)
Nonzero current accounts must be financed by equivalent capital movements, in part induced by appropriate structure of interest rates.
We will discuss this further in many posts and for now here’s a good illustration of how the balance of payments accounts are kept. This is from the Australian Bureau of Statistics’ manualBalance of Payments and International Investment Position, Australia, Concepts, Sources and Methods, 1998
(click to enlarge)
So, one starts out with the international investment position and records the transactions in the current account and the financial account. The difference is that the former records income/expenditure flows while the latter records financing flows. The current account includes items such as imports, exports, dividends, interest payments paid to/received from non-residents etc., while the capital account records transactions such as residents’ purchases of assets abroad, increase in liabilities to non-residents and so on. Since debits and credits equal, the balances in the two accounts cancel out. To calculate the international investment position, we add the financial account flows and calculate revaluations to reach the end of period international investment position.
The international investment position records assets and liabilities vis-à-vis the rest of the world. If the difference – the NIIP – is negative, it means the nation is a debtor nation. In the construction above, all transactions between residents and non-residents are recorded – whether in domestic or foreign currency. The numbers are then converted to the domestic currency according to the best rules prescribed by national accountants.
We will look into these in more detail – including all causalities of course – in later posts in this series. Till then, the summary is: imports are purchased on credit.
Readers of this blog may be aware of my fanhood for Wynne Godley and the title of this post is from a paper by him from 2004, although it was US-centric. This post is on imbalances in the Euro Area.
Wynne had not only always foreseen crises, but also knew about the muddle in the public debate and in academia both before and after the crises and the policy space available to resolve the crisis. Here’s from the short paper:
The public discussion is fractured. There are vacuous suggestions coming from sections of Wall Street that Goldilocks has been reincarnated and everything is fine. There are right-wing voices calling unconditionally for cuts in the budget deficit. The Bush administration seems complacent and, thank goodness, is not being convinced about cutting the federal budget deficit any time soon. Many are concerned about the current account deficit. Some of them fear a big and “disorderly” devaluation of the dollar while others think the dollar isn’t falling enough. No one has a clear idea about what can actually be done, by whom, and when. I have no sense that anyone who pontificates on these matters (outside the Levy Institute!) does so with the benefit of a comprehensive stock-flow model—the indispensable basis for competent strategic thinking.
In his 1983 book Macroeconomics, with Francis Cripps, he wrote:
… Our objective is most emphatically a practical one. To put it crudely, economics has got into an infernal muddle. This would be deplorable enough if the disorder was simply an academic matter. Unfortunately the confusion extends into the formation of economic policy itself. It has become pretty obvious that the governments of many countries, whatever their moral or political priorities, have no valid scientific rationale for their policies. Despite emphatic rhetoric they do not know what the consequences of their actions are going to be. Moreover, in a highly interdependent world system this confusion extends to the dealings of governments with one another who now have no rational basis for negotiation.
Eurostat, the statistical office of the European Union published for the first time today the indicators of the “Macroeconomic Imbalances Procedure Scoreboard”.
The Headline Indicators Statistical Information release provides detailed data (since 1995) for current account imbalances, the net international investment position, share of world exports, private credit flow (net incurrence of liabilities discussed in the previous post), private debt and the general government debt for the EU27 countries not just EA17. People a bit familiar about Post Keynesian Stock-flow coherent macro models will be aware of the connection between these.
The flow accounting identity
NL = PSBR + BP
where NL is the Net Lending of the private sector to the rest of the world, PSBR is the Public Sector Borrowing Requirement, equal to the government’s deficit and BP is the current balance of payments (or simply the current account balance) adds to stocks of assets and liabilities via the short-hand equation (also mentioned in the previous post)
and hence the connection between the stocks and flows mentioned by Eurostat. The report also provides data for Real Effective Exchange Rates, Normal Unit Labour Costs, evolution of House Prices (which rise faster in booms and do the opposite in busts) relative to prices of final consumption expenditure of households.
The Euro Area was formed with the “intuition” that by having a single currency, among other advantages – the nations would not have balance-of-payments problems at all.
Wynne Godley saw this muddle as early as 1991:
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Writing for The Observer where he said:
… But more disturbing still is the notion that with a common currency the ‘balance or payments problem’ is eliminated and therefore that individual countries are relieved of the need to pay for their imports with exports.
Quite the reverse: the existence or a common currency makes a country more directly dependent on its ability to sell exports and import substitutes than it was before, particularly as it will then possess no means whereby it can (in the broadest sense) protect itself against failure.
and that:
… If we are to proceed creatively towards EMU, it is essential to break out of the vicious circle of ‘negative integration’— the process by which power is progressively removed from individual governments without there being any positive, organic, all-European alternative to transcend it. The nightmare is that the whole country, not just the countryside becomes at best a prairie, at worst a derelict area.
The Eurostat is a statistical organization and its job is to report and maybe suggest some policies to the policy makers. It has rightly identified the imbalances which are looking for a policy. Unfortunately, these imbalances are typically brought to a balance (or at least attempted to) by deflating demand and hence reducing output and increasing unemployment. The recent treaty changes with a new “fiscal compact” shows what the policy makers are trying to do. But they do not realize its implications!
Here’s from a 1995 articleA Critical Imbalance in U.S. Trade written by Godley:
Refuting the “Saving is Too Low” Argument
It is sometimes held that, in the words of the Economist (May 27. 1995, p. 18), “America’s current account deficit is enormous because its citizens save so little and its government spends too much.” The basis for this proposition is the accounting identity that says that the private sector’s surplus of saving over investment is always equal to the government’s deficit plus (or minus) the current account surplus (or deficit). As this relationship invariably holds by the laws of logic, it can be said with certainty that if private saving were to increase given the budget deficit or if the budget deficit were to be reduced given private saving, the current account balance would be found to have improved by an exactly equal amount. But 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.
and also in The United States And Her Creditors: Can The Symbiosis Last? (link) from 2005:
A well-known accounting identity says that the current account balance is equal, by definition, to the gap between national saving and investment. (The current account balance is exports minus imports, plus net flows of certain types of cross-border income.) All too often, the conclusion is drawn that a current account deficit can be cured by raising national saving—and therefore that the government should cut its budget deficit. This conclusion is illegitimate, because any improvement in the current account balance would only come about if the fiscal restriction caused a recession. But in any case, the balance between saving and investment in the economy as a whole is not a satisfactory operational concept because it aggregates two sectors (government and private) that are separately motivated and behave in entirely different ways.
The European Commission has taken the report and produced another titled “Alert Mechanism Report” which has this table called “MIP Scoreboard” which highlights the imbalances in grey:
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and makes observations on many individual nations – e.g., for Spain:
Spain: the economy is currently going through an adjustment period, following the build-up of large external and internal imbalances during the extended housing and credit boom in the years prior to the crisis. The current account has shown significant deficits, which have started to decrease recently in the context of the severe economic slowdown and on the back of an improving export performance, but remain above the indicative threshold. Since 2008 losses in price and cost competitiveness have partially reversed. While the adjustment of imbalances is on-going, the absorption of the large stocks of internal and external debt and the reallocation of the resources freed from the construction sector will take time to restore more balanced conditions. The contraction in employment linked to the downsizing of the construction sector and the economic recession has been aggravated by a sluggish adjustment of wages, fuelling rising unemployment.
The above is reminiscent of the Monetarist experiments of the 70s and the 80s where wages are squeezed by deflating demand (resulting in reducing employment instead of increasing it). No suggestion is made on how wages are to be negotiated. While I do not yet the best way to say the following, here it is: while wages are cost to firms, they are incomes to households and this strategy puts higher pressure on the fall in demand and creates a more recessionary scenario.
The Euro Area had no central government which is responsible for demand management in the broadest sense and individual nations having forgotten Keynesian principles, had haphazard policies from the start. In some nations, governments had a more relaxed fiscal stance but it was not seen in their budget balances because the domestic private sectors were happily involved in having its expenditure higher than income – adding to stronger growth and hence higher tax revenues. Thus the budget balance was seen under control. In others, this may have been the result of the private sector itself contributing to most of the increase in domestic demand by high net borrowing. The high growth in private sector incomes also led to deterioration in external balances of the weaker nations and the whole process was allowed to go due to irresponsible behaviour of the financial sector which was underpricing risk. Everyone was acting as if there was no balance-of-payments constraint (sectoral imbalances in general) which will hit hard someday.
When the crisis hit, governments realized that they had given up the ultimate protection (and simultaneously the lenders to governments) – making a draft at their home central bank.
Let me offer an intuition on sectoral balances in general and not just for the Euro Area. While it is true that a “good” sectoral balance is one in which all the “three financial balances” are near zero, it is important that policy be designed (and bargained at an international level) so that these balances are brought to their preferred paths of staying near zero in the medium term without affecting the aim of full employment.
So imagine a closed economy. Most economists would suggest that – under certain conditions – the government should design policy to aim to reach a budget surplus (or a primary surplus) but this comes at the cost of lower demand and higher employment and hence a poor strategy. A higher fiscal stance – as opposed to targeting a balanced budget – will automatically lead to primary surpluses in the medium term because of the increase in demand and national income leading to increases in the government’s tax receipts. In open economies this gets complicated. Under the current arrangement a unilateral fiscal expansion by a nation such as Spain is ruled out because this will bring about a return to high current account deficits because of a faster rise in domestic demand than domestic output putting the nation on a different unsustainable path.
Now this may sound like TINA – but it is not if one thinks of alternative strategies which are aimed at bring the three financial balances from getting out of hand but with a coordinated fiscal reflation. However, this is difficult without there being institutional means of achieving the desired outcome and hence there is an urgent need for a more integrated Europe with higher spending and taxing powers for the European Parliament (unlike the 2% budget rule of Charles Goodhart) which will be induced in substantial fiscal transfers. Competitiveness also needs to be addressed but the powers of the government go beyond fiscal policy alone and policies need to be designed in a more integrated Europe which reduce transfer addiction such as a common wages policy as suggested by George Irvin and Alex Izurieta in their article Fundamental Flaws In The European Project (August 2011):
Policy action is necessary if these trade imbalances are gradually to disappear. Crucially, labour productivity must increase faster in the deficit countries than in the surplus countries, an aim difficult to achieve unless proactive fiscal policy and infrastructure investment trigger a modernising wave of “crowding in” private investment. This means that Europe must redistribute investment resources from rich to poor regions. In addition, if higher labour productivity growth is to be achieved in the periphery, a “common wages policy” (not to be confused with a common wage) must be adopted which better aligns wage and productivity growth and sustains aggregate demand. This will not be achieved with wage disparities exercising a deflationary impact on the union. In the absence of national exchange rate realignment, adjustment must take place through a regional wage bargaining process.
Update: The European Commission background paper “Scoreboard For The Surveillance Of Macroeconomic Imbalances” is available at here.
Nicholas Kaldor’ resembled Keynes more than any other twentieth-century economist because of the breadth of his interests, his wide-ranging contributions to theory, his insistence that theory must serve policy, his periods as an adviser to governments, his fellowship at King’s and, of course, his membership of the House of Lords.
I was reading this article (for the 3rd time!) Kaldor And The Kaldorians by John E. King. It appears as a chapter in the book Handbook Of Alternative Theories Of Economic Growth edited by Mark Setterfield.
I came across this strong Kaldorian view (which I share):
How, exactly, does the constraint [balance-of-payments constraint] operate? Three mechanisms can be distinguished. First, in extreme cases like Cuba in the 1990s and Zimbabwe in the 2000s, a shortage of foreign exchange makes it impossible fully to operate the existing capital stock (since spare parts can no longer be imported), and growth declines or becomes negative. Second, during the fixed exchange rate regime imposed by the Bretton Woods system (1945–73), governments were forced to implement deflationary monetary and fiscal policies to protect the currency in face of often quite small payments deficits. This generated the “stop–go” cycle that Kaldor regarded as the principal cause of Britain’s poor growth performance in this period. Third, in a floating exchange rate regime, the principal constraint on output growth is the rate of growth of export demand. Kaldor himself came to believe that exports were the only source of autonomous aggregate demand, since all other categories of expenditure were fully determined by income: consumption directly, investment indirectly through the accelerator coefficient, and government spending indirectly through taxation receipts, themselves a function of income. This is a characteristically extreme position, which is difficult to justify. But it is not necessary to deny the existence of some autonomous consumption, investment and government spending in order to recognise the importance of export demand as a factor in economic growth. For most small countries, and for all regions within countries, exports are indeed the most important factor.
I am not sure if King’s description of Kaldor and the Kaldorians is the best but a decent one. So, as King hints, Kaldor fully understood the injection to demand due to government expenditure and private sector borrowing. In fact, one whose views closely resembled that of Kaldor was Wynne Godley.
How are exports determined?
Nicholas Kaldor, Geneva, 1948
Picture source: Economica
Kaldor had the following to say:
The growth of a country’s exports should itself be considered as the outcome of the efforts of its producers to seek out potential markets and to adapt their product structure accordingly. Basically in a growing world economy the growth of exports is mainly to be explained by the income elasticity of foreign countries for a country’s products; but it is a matter of the innovative ability and adaptative capacity of its manufacturers whether this income elasticity will tend to be relatively large or small.
in “The role of Increasing Returns, Technical Progress and Cumulative Causation in the Theory of International Trade and Economic Growth”, Economie Appliquée, 1981
This is oft-quoted by economists who are inspired by Kaldor’s work. This may look straightforward but in my opinion, it is not so in practice. There are just too many different kinds of stories one hears about the external sector from economists. In stock-flow-consistent Post Keynesian macro modelling literature, one sees equations such as
The algebra is involved and there are many more equations than the above two. To get exports and imports, one has to multiply the x£ and im£ by prices. Refer Godley&Lavoie’s text Monetary Economics, oft referred in this blog.
The above equation assumes important causalities. Exports of a nation depends on prices of exported products relative to domestic prices of products in the foreign country, for example. In addition, exports also depend on demand and income in the foreign country(y$). The parameter ε2 (and μ2 from foreigners’ viewpoint) is what Kaldor is talking of in the quote above. The more competitive producers in the £-country are, the higher ε2 will be. Of course, this is not the only important thing, and prices are also important. (For example, if the GBP starts appreciating, UK exporters will face pressures in selling their products in the US).
The above equation also shows that if there are injections to demand, such as from government expenditure or tax cuts or due to higher private expenditure (either by higher borrowing or an increased propensity to consume etc), imports will increase. Similarly, if there is a contraction, imports will decrease as was evident by the collapse of world trade due to recessions in many parts of the world during the “Great Recession”.
The purpose of my post was to highlight what importance economists give to price-elasticity and income-elasticity of exports/imports. Most economists worry too much about ε1 (and μ1) and Kaldorians pay much more attention to ε2 (and μ2) and what sorts of policies governments should follow based on this. For example, a nation’s government may be concentrating too much in promoting exports of goods and services where price-competitiveness plays a role. It may be beneficial if it switches to promoting exporting goods and services in which it has unique capabilities which if successful will greatly improve its external situation.
In fact, according to the work of Kaldorians such as Anthony Thirwall and John McCombie, growths of nations can be explained by the ratio of the rate of growth of exports to the income elasticity of its imports. In the stronger form, exports themselves depend on the income-elasticity of imports in the foreign nation – i.e., the “non-price competitiveness” of exporters.
