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Do current account deficits matter?

I have noticed a few commentators expressing concern about the dangers that might arise if a nation runs a persistent current account deficit. There have been suggestions that this area of analysis is the Achilles heel of Modern Monetary Theory (MMT). I beg to differ. A foundation principle of MMT is that to be able to freely focus on the domestic economy, the national government has to be freed from targetting any external goals – such as a particular exchange rate parity. The only effective way for this to happen is if the exchange rate floats freely. In this sense, the exchange rate is the adjustment mechanism for external imbalances.

MMT is built on the foundation that the national government is a monopoly issuer of its own currency and is never revenue constrained. That means it can buy whatever is available for sale in that currency at any time of its choosing. Whether it is prudent to do that at any point in time is another matter and has to be considered on a case by case basis (depending what else is going on in the economy).

However, the fact it faces no financial constraints is not a sufficient condition for a sovereign government being able to advance public purpose. The latter goal relates to maximising domestic outcomes including environmentally-sustainable growth, low unemployment, real wages growth in line with productivity, and inclusive social policies.

To be able to freely focus on the domestic economy, the national government has to be freed from targetting any external goals – such as a particular exchange rate parity. The only effective way for this to happen is if the exchange rate floats freely.

To appreciate that point consider how a fixed exchange rate system operated.

Fixed exchange rates

The Bretton Woods System was introduced in 1946 and created the fixed exchange rates system. Governments could now sell gold to the United States treasury at the price of $USD35 per ounce. So now a country would build up USD reserves and if they were running a trade deficit they could swap their own currency for USD (drawing from their reserves) and then for their own currency and stimulate the economy (to increase imports and reduce the trade deficit).

The fixed exchange rate system however rendered fiscal policy relatively restricted because monetary policy had to target the exchange parity. If the exchange rate was under attack (perhaps because of a balance of payments deficit) which would manifest as an excess supply of the currency in the foreign exchange markets, then the central bank had to intervene and buy up the local currency with its reserves of foreign currency (principally $USDs).

This meant that the domestic economy would contract (as the money supply fell) and unemployment would rise. Further, the stock of $USD reserves held by any particular bank was finite and so countries with weak trading positions were always subject to a recessionary bias in order to defend the agreed exchange parities. The system was politically difficult to maintain because of the social instability arising from unemployment.

So if fiscal policy was used too aggressively to reduce unemployment, it would invoke a monetary contraction to defend the exchange rate as imports rose in response to the rising national income levels engendered by the fiscal expansion. Ultimately, the primacy of monetary policy ruled because countries were bound by the Bretton Woods agreement to maintain the exchange rate parities. They could revalue or devalue (once off realignments) but this was frowned upon and not common.

This period was characterised by the so-called “stop-go” growth where fiscal policy would stimulate the domestic economy, drive up imports, put pressure on the exchange rate, which would necessitate a monetary contraction and stifle economic growth.

Whichever monetary system of those that have been tried in the past – pure gold standard or USD-convertible system backed by gold – the constraints on the ability of government to advance public purpose were obvious.

The gold standard as applied domestically meant that existing gold reserves controlled the domestic money supply. Given gold was in finite supply (and no new discoveries had been made for years), it was considered to provide a stable monetary system. But when the supply of gold changed (a new field discovered) then this would create inflation.

So gold reserves restricted the expansion of bank reserves and the supply of high powered money (Government currency). The central bank thus could not expand their liabilities beyond their gold reserves (although it is a bit more complex than that). In operational terms this means that once the threshold was reached, then the monetary authority could not buy any government debt or provide loans to its member banks.

As a consequence, bank reserves were limited and if the public wanted to hold more currency then the reserves would contract. This state defined the money supply threshold.

Some gymnastics could be done to adjust the quantity of gold that had to be held. But overall the restrictions were solid.

The concept of (and the term) monetisation comes from this period. When the government acquired new gold (say by purchasing some from a gold mining firm) they could create new money. The process was that the government would order some gold and sign a cheque for the delivery. This cheque is deposited by the miner in their bank. The bank then would exchange this cheque with the central bank in return for added reserves. The central bank then accounts for this by reducing the government account at the bank. So the government’s loss is the commercial banks reserve gain.

The other implication of this system is that the national government can only increase the money supply by acquiring more gold. Any other expenditure that the government makes would have to be “financed” by taxation or by debt issuance. The government cannot just credit a commercial bank account under this system to expand its net spending independent of its source of finance. As a consequence, whenever the government spent it would require offsetting revenue in the form of taxes or borrowed funds.

Ultimately, Bretton Woods collapsed in 1971. It was under pressure in the 1960s with a series of “competitive devaluations” by the UK and other countries who were facing chronically high unemployment due to persistent trading problems. Ultimately, the system collapsed because Nixon’s prosecution of the Vietnam war forced him to suspend USD convertibility to allow him to net spend more. This was the final break in the links between a commodity that had intrinsic value and the nominal currencies. From this point in, governments used fiat currency as the basis of the monetary system.

As I have written in the past, elaborate institutional mechanisms have survived the collapse of the convertible currency system which make it look as if the government is funding its net spending by bond issues. The reality is that in a fiat currency system all the government is doing when it issues debt is draining reserves which it has created itself. I use the term – “its a wash”. The government really just borrows back what it has spent.

The important point is that the imposition of fixed exchange rates constrained the capacity of the government to pursue public purpose.

Flexible exchange rates

Many progressives think that flexible exchange rates is a neo-liberal policy because it was fiercely advocated by Milton Friedman during the 1960s. His advocacy for flexible rates was based on his view that all prices should be fully flexible so that markets can work. MMT advocates flexible exchange rates because it is the only way that the macroeconomic policy tools (fiscal and monetary) can be totally free to pursue domestic policy agendas. They do not become compromised by the need to defend a parity.

If progressives really understood this point they would be on much more solid ground when they argue for “Keynesian-style” expansionary policies.

The flexible exchange rate system means that monetary policy is freed from defending some fixed parity and thus fiscal policy can solely target the spending gap to maintain high levels of employment and other desirable policy objectives. The foreign adjustment is then accomplished by the daily variations in the exchange rate.

Please read my blog – Gold standard and fixed exchange rates – myths that still prevail – for more discussion on the differences between monetary systems.

Under flexible exchange rates, the sovereign government has more domestic policy space than the mainstream economists acknowledge. The government can make use of this space to pursue economic growth and rising living standards even if this means expansion of the Current Account deficit (CAD) and depreciation of the currency.

While there is no such thing as a balance of payments growth constraint in a flexible exchange economy in the same way as exists in a fixed exchange rate world, the external balance still has implications for foreign reserve holdings via the level of external debt held by the public and private sector.

It is also advisable that a nation facing continual CADs foster conditions that will reduce its dependence on imports. However, the mainstream solution to a CAD will actually make this more difficult.

Indeed, IMF lending and the accompanying conditions that are typically imposed on the debtor nation almost always reduce the capacity of the government to engineer a solution to the problems of inflation and falling foreign currency reserves without increasing the unemployed buffer stock. A policy strategy based largely on fiscal austerity will create unacceptable levels of socio-economic hardship.

Targets to reduce budget deficits may help lower inflation, but only because the “fiscal drag” acts as a deflationary mechanism that forces the economy to operate under conditions of excess capacity and unemployment.

This type of deflationary strategy does not build productive capacity and the related supporting infrastructure and offers no “growth solution”. And fiscal restraint may not be successful in lowering budget deficits for the simple reason that tax revenue can fall as the taxable base shrinks because economic activity is curtailed.

Moreover, the lessons of how the international crises of the 1990s and early 2000s were dealt with should not be forgotten: fiscal discipline has not helped developing countries to deal with financial crises, unemployment, or poverty even if they have reduced inflation pressures.

There are also inherent conflicts between maintaining a strong currency and promoting exports – a conflict that can only be temporarily resolved by reducing domestic wages, often through fiscal and monetary austerity measures that keep unemployment high. The best way to stabilise the exchange rate is to build sustainable growth through high employment with stable prices and appropriate productivity improvements.

A low wage, export-led growth strategy sacrifices domestic policy independence to the exchange rate – a policy stance that at best favours a small segment of the population.

Is a current account deficit a problem?

We continually read that nations with current account deficits (CAD) are living beyond their means and are being bailed out by foreign savings. This claim is particularly potent in the current US-China context.

In MMT, this sort of claim would never make any sense. A CAD can only occur if the foreign sector desires to accumulate financial (or other) assets denominated in the currency of issue of the country with the CAD. This desire leads the foreign country (whichever it is) to deprive their own citizens of the use of their own resources (goods and services) and net ship them to the country that has the CAD, which, in turn, enjoys a net benefit (imports greater than exports). A CAD means that real benefits (imports) exceed real costs (exports) for the nation in question.

There are complications where one currency (USD) is a reserve currency widely used throughout the world in resolving trade. But ultimately, this is only a complication.

A CAD signifies the willingness of the citizens to “finance” the local currency saving desires of the foreign sector. MMT thus turns the mainstream logic (foreigners finance our CAD) on its head in recognition of the true nature of exports and imports (see below).

Subsequently, a CAD will persist (expand and contract) as long as the foreign sector desires to accumulate local currency-denominated assets. When they lose that desire, the CAD gets squeezed down to zero. This might be painful to a nation that has grown accustomed to enjoying the excess of imports over exports. It might also happen relatively quickly. But at least we should understand why it is happening.

Sterilisation enters the scene here as well. It is often erroneously thought that financial inflows (corresponding to the CAD) via the capital account of the Balance of Payments boost commercial bank reserves. Mainstream economists who operate within the defunct money multiplier paradigm think this might be inflationary because it will stimulate bank credit creation.

The flawed logic is – increased bank reserves -> increased capacity to lend -> increased credit -> excess aggregate demand -> inflation.

You might like to read the following blogs – Money multiplier and other mythsBuilding bank reserves will not expand credit and Building bank reserves is not inflationary – to understand why that is totally at odds with the way the credit creation system operates.

The claim is that the central bank can “sterilise” this impact by selling government debt via open market operations. However, if there is excess capacity in the economy, the central bank might refrain from sterilising and allow aggregate demand to expand.

But think about what a CAD actually means. I always argue that it is essential to understand the relationship between the government and non-government sector first. A common retort is that this blurs the private domestic and foreign sectors. My comeback is that the transactions within the non-government sector are largely distributional, which doesn’t make them unimportant, but which means you don’t learn anything new about the process net financial asset creation.

In the case of CAD, what mostly happens is that local currency bank deposits held say by Australians are transferred into local currency bank deposits held by foreigners. If the Australian and the foreigner use the same bank, then the reserves will not even move banks – a transfer occurs between the Australian’s account in say Sydney, to the foreigner’s account with the same bank in say Frankfurt.

The point is that the AUD never leaves “Australia” no matter who is holding it. The same goes for the USD and all the fiat currencies.

If the transactions span different banks, the central bank just debits and credits, respectively, the reserve accounts of the two banks and the reserves move.

What happens next depends on the approach the commercial banks take to the reserve positions. We know that excess reserves put downwards pressure on overnight interest rates and may compromise the rate targetted by the central bank. The only way the central bank can maintain control over its target rate and curtain the interbank competition over reserve positions is to offer an interest-bearing financial asset to the banking system (government debt instrument) and thus drain the excess reserves.

So sterilisation in this case merely reflects the desire of the central bank to maintain a particular target interest rate and is not discretionary. The alternative is to offer a return on excess returns equivalent to the target rate.

Should CADs be prevented?

The other implication of the mainstream view is that policy should be focused on eliminating CADs. This would be an unwise strategy.

First, it must be remembered that for an economy as a whole, imports represent a real benefit while exports are a real cost. Net imports means that a nation gets to enjoy a higher living standard by consuming more goods and services than it produces for foreign consumption.

Further, even if a growing trade deficit is accompanied by currency depreciation, the real terms of trade are moving in favour of the trade deficit nation (its net imports are growing so that it is exporting relatively fewer goods relative to its imports).

Second, CADs reflect underlying economic trends, which may be desirable (and therefore not necessarily bad) for a country at a particular point in time. For example, in a nation building phase, countries with insufficient capital equipment must typically run large trade deficits to ensure they gain access to best-practice technology which underpins the development of productive capacity.

A current account deficit reflects the fact that a country is building up liabilities to the rest of the world that are reflected in flows in the financial account. While it is commonly believed that these must eventually be paid back, this is obviously false.

As the global economy grows, there is no reason to believe that the rest of the world’s desire to diversify portfolios will not mean continued accumulation of claims on any particular country. As long as a nation continues to develop and offers a sufficiently stable economic and political environment so that the rest of the world expects it to continue to service its debts, its assets will remain in demand.

However, if a country’s spending pattern yields no long-term productive gains, then its ability to service debt might come into question.

Therefore, the key is whether the private sector and external account deficits are associated with productive investments that increase ability to service the associated debt. Roughly speaking, this means that growth of GNP and national income exceeds the interest rate (and other debt service costs) that the country has to pay on its foreign-held liabilities. Here we need to distinguish between private sector debts and government debts.

The national government can always service its debts so long as these are denominated in domestic currency. In the case of national government debt it makes no significant difference for solvency whether the debt is held domestically or by foreign holders because it is serviced in the same manner in either case – by crediting bank accounts.

In the case of private sector debt, this must be serviced out of income, asset sales, or by further borrowing. This is why long-term servicing is enhanced by productive investments and by keeping the interest rate below the overall growth rate. These are rough but useful guides.

Note, however, that private sector debts are always subject to default risk – and should they be used to fund unwise investments, or if the interest rate is too high, private bankruptcies are the “market solution”.

Only if the domestic government intervenes to take on the private sector debts does this then become a government problem. Again, however, so long as the debts are in domestic currency (and even if they are not, government can impose this condition before it takes over private debts), government can always service all domestic currency debt.

How do deficits and the external sector interact?

MMT shows that fiscal deficits result in net injections of banking system reserves that due to common (voluntarily imposed) arrangements are drained through sales of government debt either in the new issue market (by Treasury) or through open market sales (by the central bank).

If these (unnecessary) voluntary arrangements which force governments to match $-for-$ their net spending with bond sales were abandoned then the central bank would start accumulating treasury assets (maybe via formal bond sales but more sensibly via some numbers in an accounting ledger to keep record of the transactions).

International financial markets would immediately (and erroneously) believe that this accumulation of represents “monetisation of the deficit”, and that this contributes to inflationary pressures, although the empirical evidence is scant. Some selling off of the currency might occur as a consequence of investors forming this expectation.

If there is inflationary pressure, it would result from the government spending, not from the bond sales that drain excess reserves.

Problems are greatly compounded if the nation has issued foreign-currency denominated debt. If this debt is issued by private firms (or households), then they must earn foreign currency (or borrow it) to service debt. To meet these needs they can export, attract FDI, and/or engage in short-term borrowing. If none of these are sufficient, default becomes necessary.

There is always a risk of default by private entities, and this is a “market-based” resolution of the problem as noted above.

If however the government has issued (or taken over) foreign currency denominated debt, default becomes more difficult because there is no well delineated international method. Often, the government is forced to go to international lenders to obtain foreign reserves; the result can be a vicious cycle of indebtedness and borrowing.

Since international lenders request austerity, domestic policy becomes hostage. For this reason, it is almost always poor strategy for government to become indebted in foreign currency. By contrast, a sovereign government can never face insolvency in its own currency.

What would happen if the government issued no debt?

When it credits the bank account of any recipient of its spending (whether this is for purchases of goods and services or for social welfare spending), the central bank simultaneously credits the bank’s reserve account. If this leads to excess reserves, these are then exchanged for treasury debt. While the IMF and other mainstream financial analysts criticise sales of treasury debt to the central bank (or corresponding accounting entries), it actually makes no difference whether treasury sells the debt to private banks. In effect the sales directly to the central bank simply bypass the bank “middlemen”.

If you think there is a difference between treasury debt being sold the central bank or to the commercial banks then you do not understand reserve accounting which is at the heart of MMT.

The reality is that the end result will be the same: the distribution of treasury debt holdings between the central bank and the private sector will depend on portfolio preferences of the private sector. These preferences are reflected in upward or downward pressure on the overnight interest rate. To hit its target, the central bank must accommodate private sector preferences by either taking the debt into its portfolio, or by selling the debt to reduce bank reserves.

The only complication is that the treasury can issue debt of different maturities. Very short-term treasury debt is equivalent to bank reserves that earn interest. Long term treasury debt is not a perfect substitute because capital gains and losses can result from changes to interest rates.

Hence if there is a lot of uncertainty about the future course of interest rates, trying to sell long-term treasury debt to private markets can affect interest rates and the term structure. For example, selling long-term debt that is not desired by the private sector will lead to low prices and high interest rates for that debt. In this case, it is not really the case that budget deficits are affecting interest rates, but rather the decision to sell debt with a maturity that is not desired by markets. The solution would be to limit treasury debt to short-term maturity.

An important point to be made regarding treasury operations by a sovereign government is that the interest rate paid on treasury securities is not subject to normal “market forces”. The sovereign government only sells securities in order to drain excess reserves to hit its interest rate target. It could always choose to simply leave excess reserves in the banking system, in which case the overnight rate would fall toward zero or whatever support rate on reserves was being offered.

When the overnight rate is zero, the Treasury can always offer to sell securities that pay a few basis points above zero and will find willing buyers because such securities offer a better return than the alternative (zero).

This drives home the point that a sovereign government with a floating currency can issue securities at any rate it desires – normally a few basis points above the overnight interest rate target it has set.

There may well be economic or political reasons for keeping the overnight rate above zero (which means the interest rate paid on securities will also be above zero). But it is simply false reasoning that leads to the belief that the size of a sovereign government deficit affects the interest rate paid on securities.

When the central bank desires to target a non-zero interest rate, budget deficits will thus lead to growing debt and increased interest payments. However, the interest rate is a policy variable for any sovereign nation which can increase its deficits and its outstanding debt while simultaneously lowering its interest payments by lowering interest rates.

A non-sovereign government faces an entirely different situation. In the case of a “dollarised” nation, the government must obtain dollars before it can spend them. Hence, it uses taxes and issues IOUs to obtain dollars in anticipation of spending.

Unlike the case of a sovereign nation, this government must have “money in the bank” (dollars) before it can spend. Further, its IOUs are necessarily denominated in dollars, which it must incur to service its debt. In contrast to the sovereign nation, the non-sovereign government promises to deliver third party IOUs (that is, dollars) to service its own debt (while the US and other sovereign nations promise only to deliver their own IOUs).

Furthermore, the interest rate on the non-sovereign, dollarised government’s liabilities is not independently set. Since it is borrowing in a foreign currency, the rate it pays is determined by two factors. First there is the base rate on the foreign currency. Second, is the market’s assessment of the non-sovereign government’s credit worthiness. A large number of factors may go into determining this assessment. The important point, however, is that the non-sovereign government, as user (not issuer) of a currency cannot exogenously set the interest rate. Rather, market forces determine the interest rate at which it borrows.

Other considerations

One commentator recently wrote:

However, the external sector has other dollar-denominated assets as well such as equities, corporate bonds and mortgage backed securities and the question is what about the rates with which such numbers grow? If a stock is held by a household, the dividend goes to it and the household may consume a part of it and it flows back to the producer. If the external sector holds the stock, it just goes to it and doesn’t flow back to the domestic sector. The US government can increase its fiscal stance but what if all the expansion goes to the external sector? In other words, there is a scenario in which the fiscal expansion improves short term demand, but doesn’t do much in the long term (for countries such as the US with a huge external debt, though denominated in the local currency).

First, the dollars never leave the country. Yes, an external holder of a USD income stream can use that stream to purchase goods and services elsewhere given the reserve status of the USD. But what is the problem? Ultimately, the holder of the USD can only realise these holdings by buying goods and services (or assets) denominated in US dollars.

Second, the advantage of fiscal policy is that it can be targetted to alter the composition of output as well as the level of output. So one of the first policies I advocate is the introduction of a Job Guarantee which would focus the public spending on the domestic economy and deliver domestic (non-tradeable) outputs. It is very hard to see a high proportion of this expansion going out of the country.

Third, more generally, the government can always buy what is for sale in its own currency. Every country has a well-developed non-tradeables sector which offers many goods and services that can be procured for the advancement of public purpose. Why would we be concerned if the government improves mental health care by increasing the educational outlays for these professions and employing increasing numbers of the graduates? Perhaps, the new workers will buy some imports. What exactly is the problem?

Fourth, all private sector decisions are made on a voluntary basis with the best knowledge that is available. If private firms are selling financial claims to foreigners they are doing this voluntarily. What is the problem? It just means the external leakage is greater and there is more space for domestically-orientated injections, without compromising the stable price objective.

The same commentator then noted:

If the dollar devalues because of market forces, the position of various domestic sectors of the US improves because the values of their external assets increases. They export more as well and this increases demand as well. However, the US dollar has been artificially high or one can say that the others have pegged theirs to lower values. The manufacturers in the US have great production capacity and products, are competitive and have good selling skills. In spite of this, manufacturing has weakened a lot in the US. The answer to why this has happened may only be in the monetary economics related to the external sector. One can say that the US government should have just increased the fiscal deficit but that would have increased the trade deficit – who wins the race ?

First, while there is some debate about the value of the import and export price elasticities, it is generally believed that a depreciating currency does have the impacts you mention. Competitiveness is enhanced without a harsh austerity drive to drive down domestic wages. This is the mechanism the EMU nations are sorely missing at the moment (among others). This stimulates exports (usually but not always) and reduces imports.

Is that a good thing? Not in itself because exports impose costs and imports provide benefits. But it may be that the aggregate demand injection boosts local jobs which is a good outcome. All these judgements depend on what happens.

Second, it is clear that China is buying US financial assets and this is having the effect of keeping their currency weak. Although recently they have let the currency follow a peg (and appreciate a little). But the Chinese can hardly liquidate its holdings of foreign currencies because then they would strengthen their own currency and undermine their own trade plan.

So their option is to buy US dollar-denominated financial or other assets to keep their own currencies weak and maintain their export competitiveness. All they are doing is depriving their own citizens of development opportunities.

Third, it is clear that the US dollar remains the safe haven and this has impacts on the competitiveness of its manufacturing sector. But that has nothing much to do with the effectiveness of the public deficits nor of the current account that the US is running. It has to do with the relative attractiveness of other currencies, most recently the Euro.

Fourth, the statement “The manufacturers in the US have great production capacity and products, are competitive and have good selling skills. In spite of this, manufacturing has weakened a lot in the US” is counter to the facts. If they were competitive (by which we mean internationally competitive) then they wouldn’t be losing market share.

The logic of the market is that consumers will demand what they think is best. It is clear that they no longer think US production fits that category. That might be heart-wrenching for the dying manufacturing towns – as it was as agriculture waned some decades earlier and communities vanished – but I doubt that you want to argue for protection where the rest of the US consumers subsidise the jobs of a few who can no longer produce attractive enough products in their own right.

Further, while manufacturing in the US has declined (as it has in most advanced nations), the high productivity manufacturing jobs have stayed in the US. The low wage jobs have been exported to China, India and elsewhere.

Finally, I don’t think this has anything to do with the effectiveness of fiscal policy.

Australia

The following graph is taken from the RBA statistics and shows in the left-panel the AUS/USD exchange rate since 1969 and in the right-panel the relationship between the exchange rate (horizontal axis) and annual inflation rate (vertical axis).

The left-panel shows you how much of a roller coaster the Australian economy is on with respect to its exchange rate. Within a decade it has gone from below 50 cents USD to nearly parity. The sky hasn’t fallen in.

The right panel shows that there is no intrinsic relationship between domestic inflation and the exchange rate. If anything it is the reverse of that which the fear mongers claims exists.

For those who think the change in the exchange rate matters, the following graph demonstrates that it doesn’t. Quarterly changes in the left-panel and annual in the right-panel.

Conclusion

That is enough for today!

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    This Post Has 105 Comments
    1. Great article that answers a lot of questions, however the elephant in the room here is still ‘oil’. Everywhere except the US is petrified of currency devaluation in case they delivered an oil shock to their economies.

    2. Bill, it’s amazing to see how an open platform like yours can maintain such high standards. The fact that you respond and incorporate some of the more demanding and intelligent arguments proves not only that you are a good teacher but that this truly is a community, as panayotis said the other day. It makes the reading experience for the more passive members like myself all the more rewarding. Thank you!

    3. Bill, it’s amazing to see how an open platform like yours can maintain such high standards (I obviously can’t see the hate mail you fend off behind the scenes). The fact that you respond to and incorporate some of the more demanding and intelligent arguments from the comments section proves not only that you are a good teacher but that this truly is a community, as Panayotis said the other day. It also makes the reading experience for the more passive / amateur ‘members’ like myself all the more rewarding. Thank you!

    4. Dear Bill

      I haven’t written to you before. So first a couple of lines as background. I retired 2 years ago from a technical job here in UK. I have no economics training but have always been interested.

      I have been trying to understand economics to understand the recent crisis and the proposed measures to get us out of the fix we are in. Not succeeded yet, but delighted to find your blog about 2 weeks ago; brightens the day up! It is enlightening that there are alternatives to the sackcloth and ashes we are about to have heaped on us. I hadn’t heard of MMT, so am trying to read and learn about it.

      First, about your latest blog. I don’t understand why you concentrated on Current Account Deficit. If you had written Trade Deficit, all would be clear to me. I had understood that MMT really didn’t worry too much about CAD provided the economy etc was not overheating etc. Can you help please?

      The blog helps with one major area of doubt / lack of understanding I have, but I can not yet really understand what the economic control measures are within MMT. It seems to me that there is a need to understand the total output from an economy in some absolute way so that countries know how near to the inflationary edge they are. Have you written about this anywhere else, please? I have this horrible feeling that I am missing something obvious!

      The other thing I am looking for with MMT is how one country like Australia or UK could follow the type of economic policies you and your colleagues advocate in a world where everyone else follows different economic theories and control all the economic levers. So put simply, what is the route map to get from where we are now to some countries following MMT principles in controlling their economy? Can we have mixed bathing, or will those that try to follow MMT whilst all the others continue as now result in the pioneers getting stripped naked!

      Perhaps I am so new to this that I just don’t understand yet, but any help or guidance you can give would be great.

      Thanks

      Richard

      PS I have many other queries, but I think I should keep this initial query short.

    5. You’ve covered a lot of ground that’s been quaking recently.

      One suggestion: in the discussion of government bonds generally, you might do a blog that specifically contrasts the nature of bond pricing under an MMT zero natural rate environment, versus an active interest rate management monetary policy. Expectations for future monetary policy are a significant pricing factor in the latter. I found the “few basis points more” discussion a little ambiguous in that sense.

    6. Again very interesting read! Guess Bill with his take on CA and Import/Export is banned from speaking in public in Germany? Speaking so would cause riots and clearly pose an acute danger to public order.

      I’ve also some other question to commenter. Some years ago I read Steven Landsburg’s “Armchair Economist” and enjoyed it. So since he is also blogging by now I’m following his blog. In his latest post leaving aside his childish ad hominem attacks on Paul Krugman he writes:

      Look. Any time the government spends money, there are two or three downsides (which might or might not be outweighed by the upsides). Call the downsides Thing One, Thing Two, and Thing Three. Thing One, the biggee, is that resources get consumed. Thing Two, which can also be pretty big, is that the program must be financed by (current or future) taxes, which discourage productive activity.

      Thanks to Bill’s relentless educational efforts it takes now only nano seconds to identify utter nonsense. My question: do you engage with such erroneous thinking via comment or simply ignore it as some sort of incurable brain conditioning? What’s your take?

    7. “So gold reserves restricted the expansion of bank reserves and the supply of high powered money (Government currency). The central bank thus could not expand their liabilities beyond their gold reserves (although it is a bit more complex than that).”

      I’ve been looking for an explanation of the “although” part for some time now. Haven’t seen it anywhere. And wonder if anybody actually knows.

    8. Bill –

      Thanks for the extra graphs. Looking at the upper part of the annual change one, there does appear to be a trend of inflation being higher the more the Australian dollar devalues against the US dollar (and lower when our dollar rises). But there’s no clear trend in the lower part of the graph.

      And thinking about it a bit, that’s not really surprising. A declining dollar is likely to increase the price of imports and commodities, so increasing inflation. But the policy of inflation targetting means that it hasn’t had the opportunity to have that effect recently. Instead we’d get higher interest rates. These would negatively impact economic growth, so I can’t agree with your conclusion that there is no problem.

    9. Time issues in writing a detailed comment on the interesting post.

      Anon:

      I believe the money supply was not exogenous in the gold standard. Money cannot but be endogenous. Rather, the recessionary environment would happen because of “fiscal policy reaction function” and/or “monetary policy reaction function”.

      Lets say settlement happens instantaneously. An import reduces reserves and gold from banks’ and central banks’ assets (respectively), but will be compensated by increase in the items “claims on banks” on the central bank assets and the reserves come back to the original. This is in overdraft economies. In asset-based economies, the central bank would purchase government debt to bring the reserves back to the original.

      For surplus countries, banks’ indebtedness to the central bank would reduce.

    10. I agree with Oliver above. Thanks Bill.

      On another note, did anyone else see the budget released by the UK today? Truly scary IMO. I cannot figure out how people in such positions of authority can be so seemingly clueless.

    11. He he Anon – even I was put off initially by the word “endogenous” or “endogeneity”. I understand it as “not fixed” or opposite of exogenous. The usual theory is that the central bank sets the money supply and so the money supply curve (rates on y-axis and supply on x-axis) is vertical. The interest rate is the point where the downward sloping demand curve (for money) would meet this vertical supply curve. And hence in this picture, interest rates are endogenous :)

    12. Re Aidan

      “Looking at the upper part of the annual change one, there does appear to be a trend of inflation being higher the more the Australian dollar devalues against the US dollar (and lower when our dollar rises).”

      By eye, you are right, and your reasoning as to why may well be correct, but consider the standard deviation shown – its enormous. There’s some weak correlation, but not a lot so there must be other strong factors

      Re Greg – Yes, I live in UK! H E L P!!!

      Richard

    13. “It is often erroneously thought that financial inflows (corresponding to the CAD) via the capital account of the Balance of Payments boost commercial bank reserves.”

      I’ve always been a little unclear on the specifics of why the capital account must equal the current account. I certainly get the algebra (Balance of Payments = Current Account – Capital Account), but I don’t clearly understand the mechanism through which the two terms come into balance. It is my understanding that the Capital Account is equal to the net change in financial flows entering/leaving a country. So it is comprised of things like foreign direct investment (long term capital investment/disinvestment such as the purchase or construction of machinery, buildings or even whole manufacturing plants), portfolio investment (buying/selling of shares and bonds), and most important of all changes in foreign reserves held by a nation’s central bank. My question is why should a nation importing more than it is exporting (a current account deficit) necessarily lead to a corresponding increase in financial flows entering that nation (or vice-versa for a current account surplus)? When a nation runs a current account deficit it experiences a net-outflow of financial assets and in exchange receives a net inflow of real goods and services. To me this doesn’t seem to be connected to the financial flows of that nation’s trading partner(s). To take China and the U.S. for example: when the U.S. imports more than it exports it transfers dollars to China and China ships real goods and services in exchange back to the U.S. Why should China then have to transfer an equal number of Yuan back to the U.S. as foreign direct investment, portfolio investment, etc…? Is that not what the balance between the Current Account and the Capital Account implies? It seems to me that these should be two separate and independent processes. If someone has the time could he/she please try to briefly explain this relationship to me. Thank you.

    14. Richard –

      Of course there are other stronger factors. Currency devaluation is one of three components of inflation, the others being cost push and demand pull.

      Australia is a big (and comparatively remote) country, so the proportion of domestic trade is very high. And it relies heavily on exporting commodities, so commodity prices often make more difference than currency rates. But that doesn’t mean currency rates are unimportant – it merely means they’re one of many important variables.

    15. NKlein1553,

      If the US pays China one dollar for imported goods (current account), that dollar ends up being China’s claim (asset) on the US banking system (liability). That claim is recorded as a capital inflow into the US. It’s an automatic micro banking system accounting entry and an automatic macro accounting classification.

      The dollar outflow from the US is on current account; the mirror image dollar inflow to the US is on capital account.

    16. Ramanan,

      My impression is that mainstream economics uses these words in a generic sense wherever possible. There must be something deeply flawed with a system of thought that employs such vagueness so lavishly.

      :)

    17. Thank you anon, that was certainly succinct. I think I understand your explanation, but I guess it’s just because I’ve never taken an accounting class that the terminology seems a little strange to me. A liability is a claim someone or some institution must pay out over a set period of time. Investopedia defines liability as: “A company’s legal debts or obligations that arise during the course of business operations. These are settled over time through the transfer of economic benefits including money, goods or services.” So it seems a little counter-intuitive to me that claims on the U.S. banking system (for example, the dollars China accumulates through its current account surplus) should be recorded as as a capital inflow. I’m going to have to let your explanation sink in a little. Thanks again for your help.

    18. I can see how the importing country gets a benefit of lower-cost goods, but what about the lost jobs which have gone overseas to allow for the exporting country to produce those goods?

    19. I understand that “dollars don’t leave the country” and fairly comfortable with monetary operations here are a few things I have to say to our host and other commentators:

      Imagine a group of people forming an island and wishing to trade with the rest of the world. The international currency markets will not accept the currency unless these islanders show trade surpluses. The international currency markets possess tremendous powers to punish a country. While the state is bigger than the bond markets, it is not bigger than the currency markets. Many times, the movement is drastic and a currency can plunge causing major shocks.

      The gold standard never followed the rules of the game – in other words, the Mundell-Fleming approach was inapplicable in the Gold-Standard era. Central banks had reasonable sized assets in their balance sheets other than gold – for example, claims on banks and/or government securities. A current account deficit wouldn’t reduce the reserves as per my comment @22:57.

      I don’t mind the usage of the terminology debt monetization and neither does Anon mind. As long as we recognize that it doesn’t make a bank’s customers more credit-worthy, the usage is okay. Its even legal. If a central bank agrees to purchase government bonds directly, such things are documented. So it has an ontology. If one wishes to combine the balance sheets of the central bank and the government, then it appears funny.

      In the gold-standard, the international payments would settle in gold. This doesn’t reduce the reserves – but the central bank and the government, under the pressure of losing more gold would go into an austerity mode in order to stop further outflow. Interest rates would rise but that is the discretionary action of the central bank – the central bank reaction function, not some automatic phenomenon.

      The current account deficits were problematic because, there is a “hard thing” that a nation could lose and faced by the prospects of not being able to do international trade it would go into an austerity mode. Its a complex world, and the result could be anything including improvement of the current account. The nations also had the option of devaluation and this would put pressure on imports and improve exports – at least in theory. There are/were other advantages – the devaluation and high interest rates may bring in capital inflows because the investors may be willing to bet on an improvement and make gains through higher interest paid as well as possibilities of gains because of a possible future revaluation. The nation under pressure may feel less stressed because the capital inflow brings gold inflows and has bought time.

      The central bank reaction function may have a money target, but the reaction function can also have money targets in the fiat world – and the citizens can suffer the scourge of monetarism even in fiat currencies.

      There is another institutional setup where reserves can change because of capital inflow – the Euro Zone. It is true that the total reserves of banks of all countries is constant, it may not be true of a single country. To complicate matter, the Euro Zone is an overdraft type, the “sterilization” is automatic. Banks of countries with excess reserves automatically reduce their indebtedness to their NCBs – no operations are needed.

      What a funny word sterilization is! A neoclassical invented word – its used to denote that in the absence, there will be some sort of money multiplication! In a fiat currency like that of China, capital inflow indeed increases reserves but not directly. It increases because the central bank purchases foreign currency and pays in reserves. Yes, the sterilization is really an interest rate maintenance operation.

      Now I come to the current account deficits. An importer settles in bank money. The exporter may sell it to his local bank and the bank may purchase the government debt of the country in deficit. Or the bank can purchase other securities or sell it to a financial intermediary who may purchase some security of the deficit country. The bank may also sell the currency to its central bank and the central bank is most likely to purchase government debt. Yes of course no dollars leave the US!

      Several things can be said. The import was a volitional decision of the importer. When the importer imports, its lost income for a domestic producer. In this hand-waving way of saying things, imports reduce national income. There are other ways to show this as well but sufficient to say at this point that unless the government compensates this, national income is inversely proportional to the propensity to import. It is true that budget deficits are endogenous, but for a fiscal stance, there is nothing automatic to bring the employment back to the original level. Ceteris paribus imports increase unemployment

      There are many situation that can be analyzed when ceteris is not paribus. I will analyze them in the next comment.

    20. “In this hand-waving way of saying things, imports reduce national income.”

      Really?

      Maybe in terms of a “lost opportunity”, which is conjecture, but not in terms of fact of trade.

      The second term in (EX – IM) does not represent a loss of income.

      It’s just an elimination of what otherwise would be double counting of income in the GDP equation.

      What you can say is that imports reduce (net) financial assets of the importing country.

      But that’s not the same as income.

    21. Anon,

      Yes, from the identity, its difficult to figure out the national income. But one way to think is that X -M occurs with G – T and net exports acts a bit like the budget deficit.

    22. Continuing …

      While I understand that there is no financial constraint and that no dollars leave etc., an analogy can be given. Imports are like bleeding and national income and expenditure and be thought of as a flow of blood. Saying that current account deficit is okay and sustainable is like saying that since someone provides an infinite supply of blood, bleeding is not a problem. The fact can imports “go to” the external sector is not problematic because there is no lack of funds or money but with the analogy, not importing is like keeping the circulation inside the body in a good condition.

      Several scenarios can be analyzed when the ceteris is not paribus as per my comment @3:17.

      The fiscal policy is two variables – the government spending G and the tax rate t. It can be combined into one number G/t. The ceteris paribus in my example was really a fixed G/t. For a given fiscal stance, imports reduce national income (compared to the case when there are no imports). Because foreigners hold domestic assets and dividends and coupons are to be paid for it, it puts more downward pressure on national income.

      However, one should really be looking at different (G/t)s because that is where the argument is. That really is the case where ceteris is not paribus. Before I head into that, I would like to point out that its rarely the case that governments change the G/t ratio in the present world, that is its not always the case that a current account deficit country goes into an expansionary fiscal policy. In fact they go into a contractionary policy which is a reduction in G/t. Some changes in the definitions of G/t can be made – using real instead of nominal or, adjusting for growth or simply comparing it with the national income. So when ceteris is paribus, continuous current account deficit is problematic.

      So the question is whether the governments can act to prevent the leakage of income, even though governments do not pursue this aggressively in the present times.

      To be continued . . .

    23. “First, it must be remembered that for an economy as a whole, imports represent a real benefit while exports are a real cost. Net imports means that a nation gets to enjoy a higher living standard by consuming more goods and services than it produces for foreign consumption.”

      IMO, if the imports are paid for with currency, it is a benefit. If they are paid for using debt, it is not.

    24. anon-
      “My impression is that mainstream economics uses these words in a generic sense wherever possible. There must be something deeply flawed with a system of thought that employs such vagueness so lavishly.”

      Nobel Laureate Frederick Soddy-
      ” I thought that, as a scientific man, I ought to know something about economics. So I studied the money system for two years and could make nothing of it. Then, one day, the truth dawned on me. What I was studying was not a system, but a confidence trick.”

      That’s why we’re here.

    25. Dear anon (at 2010/06/22 at 22:25) and all

      You wrote:

      You’ve covered a lot of ground that’s been quaking recently.

      In fact, I just brought together a few blogs from last year into this one. It reveals that when readers make statements that MMT hasn’t considered this, or has ignored that, that the real problem is that the reader hasn’t read the body of work that is already available – both my academic work over many years and the more recent distillation of that work available via my blog.

      This is not an attack on anyone but an invitation to go back through the archives of my blog – there are 2 million odd words already written – a lot of repetition – but most, if not all, of the issues that get raised have been considered and written about. Maybe not to the satisfaction of the reader but that is a different point to the accusation that we have deliberately ignored important points.

      best wishes
      bill

    26. Dear Stephan

      You asked:

      My question: do you engage with such erroneous thinking via comment or simply ignore it as some sort of incurable brain conditioning? What’s your take

      If the “you” is me, then I do not. I haven’t the time to do that. I barely have time to keep this blog going. But I like to see the MMT army which is growing in size and full of zeal out there penetrating the denizens of ignorance.

      With that said, it is hard to get through to the rabid gold bugs and you have to ask yourself whether foregoing a nice cup of tea with your partner/friend or whatever (doing a crossword) is worth the sacrifice. Especially, when their blogs carry advertisements for which they make money and the more hits they get the more money they make.

      best wishes
      bill

    27. Dear Aidan (2010/06/22 at 22:54)

      Your scratching for nothing. Even very sophisticated econometric analysis (studying lag structures etc) fails to reveal any statistically significant and robust relationship.

      best wishes
      bill

    28. Dear Ramanan (at 2010/06/22 at 23:38) and anon

      Endogenous just means determined “within the system”. Exogenous means the value is not the result of the system solution and is thus external to that solution. So the central bank can set the short-run interest rate – it has the legislative power and operational tools to impose that on the system. It is exogenous.

      Deploring a word is not something that is worth spending time on.

      best wishes
      bill

    29. Dear NKlein1553 (at 2010/06/22 at 23:49)

      My question is why should a nation importing more than it is exporting (a current account deficit) necessarily lead to a corresponding increase in financial flows entering that nation (or vice-versa for a current account surplus)?

      It is a matter of accounting. The foreign exchange transactions that are implied by the current account deficit have to be evidenced in the capital account. The balancing act comes via the reserve account which records the central bank transactions in the foreign exchange markets.

      best wishes
      bill

    30. Dear Aidan (at 2010/06/23 at 0:13) and Richard (at 2010/06/22 at 23:44)

      Australia had a massive depreciation in the early 2000s (down to 49 cents in the USD) but inflation was falling throughout this period. Inflation rose slightly as the dollar went towards parity in 2007.

      best wishes
      bill

    31. Dear Gary (at 2010/06/23 at 2:53)

      You asked:

      I can see how the importing country gets a benefit of lower-cost goods, but what about the lost jobs which have gone overseas to allow for the exporting country to produce those goods?

      This is one of the quandaries of economic life. Do you try to maintain a small number (proportion of total) jobs by forcing all your population to pay more for goods and services which may also be of inferior quality – and in doing so, deprive poorer nations of the same means to develop that your own rich country used in an earlier historical period?

      In posing the issue this way, I am not lacking empathy for the communities and families in the industrial areas that lose the employment. Far from it. But ultimately, if you allow trade and allow consumers to choose what is best for them, then these global resource allocations will occur.

      But I do not support “free trade” – only “fair trade”. So I would ban products from nations where trade unionists are shot, or where wages and conditions are unfair. But even under fair trade these job reallocations will occur. So that is where I see a major role for government to stimulate new job opportunities via investment in education and R&D. Why hasn’t the US government , for example, seen the declining northern towns that used to make cars as the site for massive investment in renewable energy development and production?

      best wishes
      bill

    32. “It reveals that when readers make statements that MMT hasn’t considered this, or has ignored that, that the real problem is that the reader hasn’t read the body of work that is already available”

      Fine. Forget my suggestion. You must have already “considered” it. So you don’t need to “cover” it once more.

    33. Clearly we are currently in uncharted territory- globally.

      The good news is that we are are going to have some great data in coming years to re test the CAD debate, which was last at its peak in Australia in the recession of the early 1990’s. The RBA/Treasury line was then that domestic demand had to be crushed with extreme monertary policy settings to address a relativly moderate CAD. Remember the banana republic with a CAD at 5-6% of GDP.

      Of course, now the conventional wisdom has turned fully circle, ie, the private sector can determine its own optimal level of contribution to the CAD, and any government borrowing should be spent on initiatives that improved nationally productivity like infrastructure.

    34. Dear Ramanan (at 2010/06/23 at 4:35)

      You said:

      The fact can imports “go to” the external sector is not problematic because there is no lack of funds or money but with the analogy, not importing is like keeping the circulation inside the body in a good condition.

      But you ignore the real benefits that arise from the imports. They help keep the “consumer” in good condition. I don’t think your analogy in this case is applicable.

      Further, the loss of income to imports (actually net exports) provides fiscal room to create public goods and services without hitting the real capacity limits.

      best wishes
      bill

    35. Wow, a lot of comments here:

      First, you seem to be suggesting that there are only two policy options: flexible or fixed exchanged rates. But when some nations are pegging, the country pegged to can certainly impose tarrifs and fees to counterbalance some of the current account manipulation without resorting to a fixed exchange rate.

      Second, in the statement

      imports represent a real benefit while exports are a real cost. Net imports means that a nation gets to enjoy a higher living standard by consuming more goods and services than it produces for foreign consumption.

      Because a nation imports more does not mean it consumes more — it can consume more, less, or the same amount. The geographic transfer of production from one nation to another does not mean that the nation losing capital enjoys a benefit of additional consumption. Whether or not it does depends on what else happens to the freed resources and what the multiplier effects are from the loss of income — you cannot use a partial equilibrium analysis here, and you need to distinguish between outsourcing — shifting production out of the country — with import competition.

      But all the analysis assumes that the form of trade is import competition. According to this model there are Chinese firms that outcompete U.S. firms — this is not happening. This did happen with the trade deficit with Japan, but not with China. With China, we do not consume more — we consume the similar goods for a similar price, but the goods were made elsewhere, and the income for producing those goods also goes elsewhere. This obviously creates internal income imbalances with the U.S. and also with China, and requires a certain level of debt growth.

      Third:

      For example, in a nation building phase, countries with insufficient capital equipment must typically run large trade deficits to ensure they gain access to best-practice technology which underpins the development of productive capacity.

      No — using the same cet. par. assumption that you assumed when arguing that net imports increase aggregate consumption, you would assume that a nation acquiring foreign capital would need to run a trade deficit due to the foreign capital inflows.

      It’s bizarre to argue that developing nations need to, or historically have, experienced a net outflow of capital. As Krugman says, that is making “water run uphill”.

      I don’t believe in either of these ceteris paribus assumptions.

      Development requires trade, but not trade deficits. The whole purpose of flexible exchange rates is for the terms of trade to adjust leaving no long run surpluses or deficits.

      Apart from the asian development model — which is recent — nations developed by running small deficits or relatively balanced trade up until they had all the foreign capital needed — which is small — and then they could use those skills and tools to provide more goods for their own domestic population as well as compete with foreign producers.

      Even in the era of mercantilism, the trade surpluses were never viewed as a means for undeveloped nations to develop, but was a means for already developed nations to prevent others from developing due to the zero-sum mentality. Mercantilism was all about the nation with the most advanced business sector and strongest navy forcing open the markets of weaker, less developed nations.

    36. >However, the fact it faces no financial constraints is not a sufficient condition for a sovereign government being able to advance public purpose. The latter goal relates to maximising domestic outcomes including environmentally-sustainable growth, low unemployment, real wages growth in line with productivity, and inclusive social policies.

      Its called “GPEC”

      http://delusionaleconomics.blogspot.com/2010/06/gpec-how-could-australia-get-more-of-it.html

      The point is to find a balance between all of these.

    37. “The balancing act comes via the reserve account which records the central bank transactions in the foreign exchange markets.”

      Can someone explain to me what exactly happens in this balancing act? Assuming there are only two countries, the U.S. and China, here are some hypothetical transactions that might take place along with my questions:

      1) The U.S. runs a current account deficit transferring dollars from the U.S. commercial banks U.S. importers use into the Chinese commercial banks Chinese exporters use.

      2) The Chinese commercial banks exchange the dollars Chinese exporters earned into Chinese Yuan and credit the Chinese exporters’ bank accounts with Yuan. My question is who facilitates this exchange? Is the Chinese central bank exchanging the dollars Chinese exporters earned for Yuan? Or are there private financial institutions that do this? Or both?

      3) Chinese financial institutions (including possibly the Chinese central bank) now hold the dollars the Chinese exporters earned through trade. My question is where are these dollars held? Are they held in a special reserve account set up by the Chinese central bank? Or are they held in a reserve account set up by the U.S. central bank (the Federal Reserve)?

      4) Presumably Chinese financial institutions (including possibly the Chinese central bank) will want to do something with these dollars besides hold them as reserves in some account somewhere. Perhaps Chinese financial institutions will convert their dollar reserves into a dollar denominated financial asset like a treasury bond, corporate bond, or some equity instrument. Or maybe the Chinese financial institutions will choose to invest in a tangible asset like real estate or industrial machinery instead. My question is do Chinese financial institutions have to actually invest their dollar reserves in something (bonds, shares, industrial equipment, real estate, etc…) for the U.S. to run a capital account surplus? Or does the mere fact that Chinese financial institutions possess dollar reserves equate to a U.S. capital account surplus? Again, maybe it is just my unfamiliarity with accounting terminology, but I would think that for the U.S. to run a capital account surplus the Chinese financial institutions would have to use their dollar reserves to actually invest in something. But then I don’t see why the mere fact that the U.S. imports more than it exports (a current account deficit) should *force* Chinese financial institutions to make some sort of an investment. They could just sit on their dollar reserves if they were so inclined. It might not make much economic sense for them to do so, but they could. So what is the mechanism that translates a U.S. current account deficit into a capital account surplus?

      Sorry for all the questions. I know this blog isn’t supposed to be an economics tutorial just for my benefit so Professor Mitchell if you want to delete this post I would understand. Although, maybe other neophytes have questions similar to mine. I should probably know this stuff anyway as I sometimes teach economics to high school students. It’s just that I’ve never been too clear on precisely why the current account equals the capital account even though I’ve read and reread the relevant sections of my college econ textbooks several times. Thanks in advance to anyone who can help me.

    38. And in regards to the asian development model, I’d recommend the comments of Michael Pettis — from his most recent post

      […] if the nominal exchange rate is not allowed to rise, policymakers can still contain inflation by what economists call financial repression, made possible by their control over the banking system in countries where banks completely dominate the financial system. In the Chinese context, financial repression exists because the vast bulk of Chinese savings is in the form of bank deposits, and the deposit rate is set at extremely low levels.

      This has the effect of transferring large amounts of income away from net savers, which for the most part consists of Chinese households, and in favor of net users of capital. Net users, of course, consist primarily of large, capital intensive businesses, real estate developers, infrastructure investors and local and central governments, including the People’s Bank of China, the largest net borrower of renminbi in China. Net savers are forced into subsidizing net users, in other words.

      The consequence is that monetary growth is channeled not into household demand but rather into the production of more goods, and the inflationary impact of monetary expansion is muted. Financial repression is an alternative to currency appreciation or inflation […] It leads to overinvestment, asset bubbles, and rising excess capacity. By keeping the cost of capital in China very low – perhaps as much as 5-8% below a rate that would impose a fair distribution of the benefits of economic growth between savers and users of capital – it results in a surge in investment which, allied with large-scale socialization of credit risk, can lead at first to a rapid increase in economically viable investment but ultimately, if left unchecked, results in capital continuing to pour into investment long after its returns are uneconomical.

      I think it is pretty clear that during the last few years, and perhaps even longer, we have migrated into a state where the correctly valued costs of Chinese investment in infrastructure, real estate development, manufacturing capacity, and government spending, exceed the economic benefits…

      I should add that if much of this investment is non-economic, as I believe it is, this will exacerbate even further the differential. Why? Because the total economic cost of the investment (which must include the real debt forgiveness implied by excessively low interest rates), and which will be borne over the future as the cost are amortized in the form of debt repayment, exceeds the total economic value of the investment (which must include externalities), which will accrue upfront. This means that we get more investment-driven growth today and less consumption-driven growth tomorrow.

    39. NKlein1553,

      “So what is the mechanism that translates a U.S. current account deficit into a capital account surplus?”

      Thought I answered that in first principle terms. It’s a debit drawn on a US bank account (e.g. check, draft, wire transfer, etc.), paid to somebody in China, who must get credit for the same amount, which ultimately becomes a claim on a US bank. The debit is the current account outflow. The credit is the capital account inflow.

      Most of that capital account flow gets transferred to the Chinese central bank when exporters sell their dollars to their commercial banks who then sell them to the PBOC. Central bank reserves are a capital account outflow.

      You’ve asked some really great questions about the underlying operational details.

      Unfortunately, you won’t get the detailed answers here.

      Except that most of the dollars flow into the Chinese central bank and are held there as reserves. The bank buys treasuries with its dollars. That’s a mere asset composition change within the capital outflow classification.

      The central bank is “the box” on FX transactions and capital account outflows, because substantial Chinese capital (flow) controls are in place in both directions.

    40. In regards to the interest rates, I would very much wish to push this debate further by asking the participants to fully specify the banking system regulations in place.

      Clearly the arrangement we have now have led to financialization and economic rents. And yes, under this arrangement, banks can purchase government assets with zero risk-weight to their capital requirements, meaning that banks can use reserves to buy short term government assets risk-free. In that case, they are happy for the interest payment — for any interest payment, really.

      But the MMT proposal is to prevent banks from purchasing any asset other than loans that they make to customers. That means that banks cannot buy bonds. And in that environment, you will not be able to use this mechanism to allow the interbank rate to propagate to short term rates.

      So the level of “control” the government has depends heavily on the set of institutional arrangements that are in place.

      When talking about these rate trade offs, please specify the set of assumptions that you are making on the banking sector. Are you working in

      * current reality, in which the government is revenue constrained, the central bank is independent, and banks carry risk and balance sheet penalties for purchasing assets that limits their ability to arbitrage between their marginal cost of reserves and the market price of assets that they can hold.

      * Mosler’s/Bill’s MMT reality, in which banks cannot buy government bonds or any other traded instruments, and must only hold cash and loans they directly made to their customers.

      * Chinese model, in which banks can buy anything and are not responsible for losses, but in exchange must charge government mandated interest rates.

      Only in the third version of reality does the government directly control interest rates. In the second version, the government controls the (long term) cost of housing and real estate only. In the first version, the government can influence, but not control, a bit of both.

      At the end of the day, interbank rates are a hidden variable of the banking system. If, tomorrow, we nationalized the banks, the economy would still continue to function and we would still have the full yield curve. There is nothing that requires OMO in order to set interbank rates. And yet you argue that the interbank rates control all the other rates. It stands to reason that there would be a propagation mechanism of allowed bank actions — in terms of the assets that they are allowed to purchase and the liabilities that they are allowed to issue — that can make this happen.

      Therefore any statement about rates need to be supplied with a fully specified context so that the propagation mechanism can be judged.

      Moreover, until you fully specify the banking system, it will be impossible to determine the effects of the no bond proposal as well.

    41. So the next question is…

      If the chinese do manage to change migrate their economy to a more sustainable model based on local demand not on exports, meaning they care less about the yuan currency peg, what are they going to do with the massive US reserves.??

      What would the chinese need that the US can provide them for their US coconut shells ?

    42. Hoju,

      That is a good question, and highlights the difference between the simple view that we have been getting excess goods from China and the more complex view that we have been expanding our supply chain and shifting production to China.

      If the first view was correct, then they would just start buying up U.S. output, increasing their standard of living — except that the U.S. output is made in China!

      Oops.

      Suppose an iPhone costs $670, $5 of which is paid to chinese laborers that assemble it, $10 is paid to coordinators to oversee that process, $200 is paid to other east asian component manufacturers who themselves outsource production to China along similar ratios (P. will like the “fractal” nature of this manufacturing process), $10 of non-hardware costs is paid to American programmers and designers, $70 is paid in royalties to patent holders, and throw in $10 for shipping, packaging, and cables. That leaves a gross margin of about 60%, or $370. Let’s keep it simple and assume that gross value added is $370.

      According to NIPA, that $370 contributes to America’s final output. Apple has “created” $370 dollars worth of goods, which, when properly deflated, constitute final output, even though the actual iphones were built overseas.

      The fact that the terms of trade are such that the Chinese workers get $5 instead of $50 dollars means that U.S. output is higher by $45.

      Then Bill says that we are enjoying the consumption of $45 more worth of stuff. No, we are not. If those savings are passed on in the form of higher wages or higher spending by those with capital income, then we would be. But nothing guarantees this, and in reality, the high gross margins do not translate to higher levels of domestic consumption.

      When you are talking about profit-boosting outsourcing, then it is “investment” — as measured by NIPA using the S=I identity — that is boosted, and not consumption.

      But the measurement of that investment is subject to many tortuous and dubious economic deflations in order to finagle Investment (which is a “real” quantity) to be equal to Savings (which is a financial quantity). A priori — the units don’t even agree.

      In the specific case of the iPhone, I claim that if the Chinese were paid $50, then Apple’s margins would fall, but iPhone prices would not increase, and U.S. households would continue to buy the same number of iPhones as they did before, but holders of capital would be somewhat poorer, and asset prices would be somewhat lower. Total output would decline somewhat — as measured by NIPA — but in reality both real investment and real consumption would not decline.

      However the trade-deficit would increase, which Bill argues means that we are consuming even more. Good for the representative household!

    43. “There are other ways to show this as well but sufficient to say at this point that unless the government compensates this, national income is inversely proportional to the propensity to import. It is true that budget deficits are endogenous, but for a fiscal stance, there is nothing automatic to bring the employment back to the original level. Ceteris paribus imports increase unemployment”

      Personally, I think this is a very important point. If governments, operating out out a neo-liberal paradigm, refuse to provide the offsetting fiscal stimulus (either via tax cuts or more spending) to ensure that the economy remains close to full employment, then the “exports are a cost, imports are a benefit” argument does lose some of its force, because it implies an ongoing output gap unresolved through, say, Bill’s Job Guarantee idea. Absent a proper fiscal stimulus, many of the benefits of imports are potential and not fully actualised.

    44. And while we are on the subject of looking (ever so superficially) at actual behavior of firms and households under different interest rate and current account regimes, let’s not ignore Dani’s recent contribution discussing an IADB report contrasting the periods of Import Substitution policies and Washington Consensus policies in Latin America (IS vs WC)

      * Labor productivity under IS grew at a rate that is double the rate under WC.

      * The rate of labor productivity growth within sectors (the component identified as “within” in the chart) was comparable under the two policy regimes.

      * The worse overall performance under WC is accounted entirely by the fact that there was much less desirable structural change — labor moving from low to high-productivity activities — under WC than under IS.

      For all its faults, IS promoted rapid structural change. Labor moved from agriculture to industry, and within industry from lower-productivity activities to higher-productivity ones. So much for the inherent inefficiency of IS policies!

      Under WC, firms and industries were able to accomplish a comparable rate of productivity growth, but they did so by shedding (rather than hiring) labor. The displaced labor went not to higher-productivity activities, but to less productive lines of work such as informality and various services. In other words, the WC ended up promoting the wrong kind of structural change.

      This account reinforces the centrality of structural change in driving rapid economic growth. It should also cause us to be wary of productivity studies that focus on what is happening within manufacturing alone. After all, productivity within manufacturing can be stellar, but if manufacturing or other high productivity sectors as a whole are rapidly shedding labor, economy-wide productivity performance will be disappointing.

      Which goes to show that an inefficient industrial sector is better than having no industrial sector at all.

      None of these structural shifts require the rogue’s gallery of a bank-dominated financial sector, low interest rates, massive trade imbalances or export-led growth.

    45. NO! I would not talk about interest rates again…..I think? I have covered it so amy times in many comments and I am tired of it. Actually, Bill in this post, as I understand him, is now very close to my position. Anybody with knowledge of Control theory will understand that you control when you match an instrument with a target because you set the instrument and manage the mechanism that determines the target. On the other hand, you can only partially support a target within a range band when the degrees of freedom within the mechanism reduce your capacity for control. So, CB everywhere, please forget LT rates and focus on the very ST rate set.

      Regarding managing excess reserves, RSJ is right about the need to consider capital adequacy considerations for bank asset allocation. As Ramanan sais banks can opt to repay CB loans with their excess reserves. Furthermore, the can also purchase foreign reserves and interest earning risk free foreign state bonds and this can reduce the need to issue/sell domestic state bonds and absorb excess reserves. Also if the risk differential is reduced, there are many studies that show that banks increase their risk taking attitude and they expand credit lines, engage in off balance sheet activities and reduce credit rationing as the asymmetry of information cost is reduced.

    46. Yes anon you did answer my question, but I thought a more detailed operational explanation would help my understanding. I don’t know why, but the fact that “central bank reserves (dollars held by the PBOC) are a capital account outflow (to the U.S.),” seems counter-intuitive to me. Thanks to you I understand the classification scheme (I think), I’m just not sure why the terms in the classification scheme are what they are. In fact, I still don’t really understand why the dollar reserves held by the PBOC are classified as capital account outflows from China to the United States if the dollars are just sitting in a reserve account somewhere. If these dollar reserves held by the PBOC are used to make an investment, that is once these claims on a U.S. banks are called in, then I wouldn’t have any trouble seeing them as adding to the U.S. capital account surplus. I’m sure there is a rhyme and a reason to the classification scheme though and I’m just being dense. Thanks again for the explanation and your patience.

    47. Exactly, P, I am trying to force people to commit to describing their proposed changes so that they can describe how these rates propagate.

      It all depends on what we let banks do with the government-set funding costs that we give them. That will determine how the government-set bank cost of funds influences the credit market rates.

      Then we can have a discussion about the effects, both intended and un-intended, of the proposed suite of changes.

      In a completely different system of bank regulation, unlimited arbitrage may be allowed. All rates might be exactly the interbank rate. Banks would crowd out all private sector investment and dominate the financial markets.

      That is the China model of financial repression.

      Alternately, the scope of arbitrage may even be reduced, weakening the relationship between the marginal cost of reserves and other rates.

      For example, if banks were not allowed to buy or sell bills or bonds, or to make loans that compete with bond sellers, then then there wouldn’t be much scope for these rates to move as a result of interbank rates moving.

      My own opinion is that some of the policies that would allow banks greater arbitrage would lead to a situation in which banks dominate the financial markets, and this would be harmful to the economy.

      But I can’t make that case as long as people do not commit to specifying their regulatory framework. The details of the framework are needed in order to determine the effects of the proposal.

      Instead, the debate seems to be stuck in a limbo situation in which the current practice of allowing banks to purchase financial assets is cited as a mechanism by which interbank rates propagate to other rates — and when I point out the economic rents inherent in that approach, then suddenly banks are not allowed to purchase paper when talking about bank reform.

      Yet the ideal MMT scenario assumes both low rates and restricted utility banking.

      It is difficult to critique such a system.

    48. bill –
      Australia had a massive depreciation in the early 2000s (down to 49 cents in the USD) but inflation was falling throughout this period.
      As Australia had a policy of inflation targetting, that is not at all surprising.

      Inflation rose slightly as the dollar went towards parity in 2007.
      And when you consider the impact of oil prices, that’s not surprising either.

      Your scratching for nothing. Even very sophisticated econometric analysis (studying lag structures etc) fails to reveal any statistically significant and robust relationship.
      Are you claiming the visually obvious relationship is an illusion?

      Look at it another way: I have explained what I think the mechanism of that relationship is, and I’m sure most mainstream economists would support me on that. If you disagree, perhaps you’d care to state what the logical flaw in my reasoning is?

    49. RSJ,

      Interesting Iphone example/analysis.

      You’ve got two different scenarios – one where US iPhone GDP is $ 370 and US iPhone imports are $ 300; a second where GDP is $ 325 and imports are $ 345.

      The argument for imports as a benefit would apply to each case. In each case, it is a benefit to the US for the US to buy iPhones, as compared to the case where Canada buys them instead, which is of no benefit to the US in the sense of imports.

      The argument as I understand it would not apply as a comparison of one case of the US importing versus the other, as in your example. The case for import benefit are non-comparable to the degree GDP is different in each case.

      I’m not sure how you compare those cases such as in your example, in the sense of how you compare and value the 1:1 trade-off between import value and GDP value. But my understanding is that such a comparison is not the point Bill is making. Maybe I’ve just missed it in his blog/comments, but I don’t think so.

    50. Re the above, in the US/Canada import comparison, the US runs a current account deficit (embedded Chinese costs) if it buys iPhones, and a current account surplus (US gross margin) if Canada buys them.

    51. RSJ,

      “I am trying to force people to commit to describing their proposed changes”

      This is a very constructive idea.

      From my own perspective, its a detailed variation on the more general idea I introduced some time ago – that MMT, in explaining the operation of the modern monetary system, tends to confuse factual and counterfactual operational arrangements.

    52. NKlein1553,

      You’re the one who’s being patient. I’ve been trying to categorize the detail without describing it in detail.

      “In fact, I still don’t really understand why the dollar reserves held by the PBOC are classified as capital account outflows from China to the United States if the dollars are just sitting in a reserve account somewhere. If these dollar reserves held by the PBOC are used to make an investment, that is once these claims on U.S. banks are called in, then I wouldn’t have any trouble seeing them as adding to the U.S. capital account surplus.”

      It may help if you visualize the capital account entirely as a financial flow and set aside for a moment any real economy knock-on effects. “Ground zero” for that financial flow is the banking system. Assume simplification in international financial transactions – suppose for a moment they’re all down by cheque. Then the marginal US import is paid by cheque. That cheque gets negotiated by the Chinese exporter via the Chinese banking system.

      The initial result is that the Chinese banking system ends up with some sort of deposit with the US banking system. It could be that a Chinese commercial bank ends up with a correspondent banking balance with Citigroup in New York. Or it could be that the Chinese central bank ends up with a deposit with the New York Fed. Whatever happens, it’s an interface between the two banking systems in their entirety.

      That initial Chinese bank deposit (with the US) is a capital inflow to the US. The reason (by assumption and construction of this example) is that deposit money has not been used (yet or at all) by China to buy imports. It’s conceptually parallel to the same type of thinking that defines saving as “not consumption”.

      If China wants to buy Treasuries or agencies with its dollars, it can, and that will be classified accordingly, still within the capital account. Dollar bank balances will be exchanged for dollar bonds. And the same holds for corporate bonds or equities.

      And if China wants to use some of that money to make a real economy investment in the US, it can. That will be classified as a direct foreign investment, still within the capital account. At this point, even with this example, it is still useful to think of the capital inflow as a financial flow. That’s because the FDI ownership will be evidenced by a claim of China on the US, which is essentially an equity financial claim (although not a publically traded equity).

      That final point makes it easy to fit the capital account balance in total directly into the MMT sector financial balances model.

      Note that incoming FDI generally constitutes a fairly low percentage of capital inflows into the US.

      Maybe the key point above is that capital account determination is done via the banking system at the outset, and the thinking is similar to saving defined as “not consumption”. The capital account is “not the current account”. If money coming in is not spent on imports (or paying interest on debt held by foreigners), then it goes back out via capital account, even if it just sits in a bank somewhere passively.

    53. NKlein1553,

      It may be useful to recall that a country’s current account deficit (capital account surplus) is equal to the excess of its domestic (real) investment over its domestic saving.

      I.e. the capital inflow (which is the financial surplus of the foreign sector), is a component source of saving for domestic investment.

      This equivalence holds at the macro level and at the micro level, after netting out all financial flows internal to the country in question.

      And the equivalence holds regardless of the FDI/non-FDI mix of the capital inflow, and regardless of the bank deposit/non bank deposit mix of non-FDI.

      I.e. – China’s bilateral surplus with the US is one component of a total foreign surplus that by accounting identity matches a level of US real investment that is not “funded” internally. That identity holds, whether China (or the world at large) is 100 per cent invested in US Treasuries or 100 per cent invested in US FDI, or any combination in between. The FDI component in all cases is just a direct micro link between capital inflows and domestic real investment, consistent with and part of the indirect macro link for the same type of equivalence across all capital inflow categories.

    54. Lots of comments read!

      Nklein,

      Its easier and more intuitive if a more technical identity is given:

      current account balance + capital account balance + official settlement account = 0,

      where the official settlement account is the settlement between central banks. So when the PBoC acquires Treasuries because of many transactions which take place from the act of an American purchasing Chinese good to the point where the PBoC actually acquires the bonds, you can think of it as changing the official settlement account instead of some capital inflow.

    55. “The United States conducts a large number of trade and financial transactions with other countries. These transactions are recorded in the U.S. balance of payments accounts. The balance of payments consists of two subaccounts. One subaccount is the current account. The current account consists largely of the trade balance, which records U.S. imports and exports of goods and services. The second subaccount is the capital and financial account (hereafter called the capital account), which records U.S. net sales or purchases of assets—stocks, bonds, loans, foreign direct investment (FDI), AND reserves—with other countries during the same time period … by economic definition, a country’s current and capital account balances must offset one another.”

      (Bank deposits are considered assets)

    56. Dear Bill,

      Thanks for the post and your responses. I absolutely agree with most things you say. Imports are great benefits in the sense that in the absence of it, producers may gain more powers and have more control over their markups and this action of their is harmful for the whole economy. Imports are like taxes and in the external sector math, the import/gdp appears together with tax/gdp in many places. At the same time, unlike taxes, one has enjoyed the benefits of a product in the case of imports. So they can be good for distribution of income as well.

      Yes, a fiscal expansion can easily counter the effect of imports and will act with very little time delay. There is no issue related with the bond markets as the government has the powers to discipline them anytime. In fact, the phrase “fiscal discipline” should be used to describe scenarios where the governments disciplines the bond market. And it will increase the national income as well. Its what happens after that which I may want to write as a follow up to the “to be continued” in a previous comment of mine.

    57. Bill wrote: “But I do not support “free trade” – only “fair trade”. So I would ban products from nations where trade unionists are shot, or where wages and conditions are unfair. But even under fair trade these job reallocations will occur.”

      Isn’t “unfair” in the eye of the beholder?

      I think that we, in the western world, have a surplus of cheap manufactured goods (often of dubious quality) and it would not be a bad idea to make these goods a little more expensive so that (a) we would not foolishly buy too many as we currently do and (b) so that higher paying jobs than burger flipping can be made available to those in our society without advanced skills.

      Isn’t the whole idea of transporting goods 12000 km just because the workers producing them happen to earn a pittance (and will for a long long time to come) run counter to our desire for environment protection? Would it not be better to manufacture such things closer to home so that we reduce the environmental degradation resulting from this long-distance transportation?

    58. I don’t deplore the use of the word “endogenous” – I like the word in fact. Its just that its difficult to internalize the word initially.

    59. I wanted to avoid talking about rates but here I go again!

      Arbitrage will not equate comparable rates in the presence of arbitrage and transaction costs ( there is a growing literature in Finance theory about that Valyanos et al.). Furthermore, as we alter the terms such as the length there are factors involved whose importance rises asymptotically (i.e., productivity growth, profit rate, risk factors) and we should adjust for them and it does not give us corner solutions or sizable crowding out. Product differentiation and diversification is still possible.

    60. Anon, your explanation at 15:31 is excellent. “…The thinking is similar to saving defined as “not consumption,” really clears things up for me. Thank you again.

    61. . . . continuing from Wednesday, June 23, 2010 at 4:35 . . .

      Before I move to the case of the United States, I should emphasize that unlike the United States, most countries do not occupy the position to import freely. The usual examples given are for the US and not the poor countries. No wonder, they wish to accumulate huge amounts of foreign exchange. Keynes put this best

      It is characteristic of a freely convertible international standard that it throws the main burden of adjustment on the country which is in the debtor position on the international balance of payments. … The contribution in terms of the resulting social strains which the debtor country has to make to the restoration of equilibrium by changing its prices and wages is altogether out of proportion to the contribution asked of its creditors. Nor is this all. … The social strain of an adjustment downwards is much greater than that of an adjustment upwards. … The process of adjustment is compulsory for the debtor and voluntary for the creditor. If the creditor does not choose to make, or allow, his share of the adjustment, he suffers no inconvenience. For whilst a country’s reserve cannot fall below zero, there is no ceiling which sets an upper limit. The same is true if international loans are to be the means of adjustment. The debtor must borrow; the creditor is under no such compulsion.

      &

      The problem of maintaining equilibrium in the balance of payments between countries has never been solved since methods of barter gave way to the use of money and bills of exchange. During most of the period in which the modern world has been evolved … the failure to solve this problem has been a major cause of impoverishment and social discontent and even of wars and revolutions.

      Oil exporters continuously demand the payment in dollars and it is no surprise that developing nations want to hoard dollars and hence have a current account surplus. The fact that they do not understand the monetary system is of no consequence – even if they did, the may still demand payment in dollars. For developing nations, face less choice – expanding fiscal policy will increase imports and drain some amount of foreign currency. For developing nations, the fiscal and monetary authorities may need to persuade international investors to accumulated their IOUs and accumulate foreign exchange by showing trade surpluses and maintain stability of exchange rates. Currency crashes are not a rare thing. Whilst there may exist a mechanism to bring the current accounts to balance, it doesn’t happen in a smooth way.

      For countries like the United States, it is less of a problem because of various reasons. However it’s not good to be confident about this fact.

      In a closed economy, firms are deficit spending units and borrow to finance their production. There is a mechanism for self-adjustment in some sense. While firms are producing, households are consuming and firms use the funds to reduce their indebtedness to banks and/or households. So one can expect their debts to stabilize with respect to net worth or other balance sheet items such as fixed capital. In the analogy of blood circulation, one can say that there is good circulation (of flow of funds). The government plays a crucial role through automatic stablizers.

      In the case of an open economy, (and when ceteris is not paribus), a nation with continuous current account deficits such as the US, the government may provide some relief by relaxing the fiscal policy. This causes the government debt to “explode” and reach “unsustainable” levels. The government debt/gdp increases exponentially. However, since the government and the central bank may control the bond markets and there is no issue with solvency. Neither does it cause any inflation. However, does the domestic production sector’s debt/networth ratio improve? The income to foreigners (from the nation less income from government bonds) will most likely increase because foreigners accumulate more assets.

      In the short run, a fiscal expansion may lead to increased consumption of domestically produced goods and some amount of reduction of debt of the domestic producers. However, in the medium run, as the current account deficit widens, domestic producers’ debt/networth ratio may easily increase as they face more competition from international producers. They may be forced to pay higher interest to borrow because of balance sheet issues. Foreign ownership of US assets is very high and the coupon incomes and dividends don’t flow back to the households.

    62. The reason I keep emphazing the flow of funds is that a flow within domestic sectors creates ripple effects throughout the economy. When a consumer spends, the producers balance sheet improves and making an observation of increased demand, the entrepreneurs increase production. When they produce, they pay more wages and the consumers spend more. When the external sector is included and goods are purchased from the external sector this multiplier effect is diluted.

    63. The argument as I understand it would not apply as a comparison of one case of the US importing versus the other, as in your example. The case for import benefit are non-comparable to the degree GDP is different in each case.

      I’m not sure how you compare those cases such as in your example, in the sense of how you compare and value the 1:1 trade-off between import value and GDP value. But my understanding is that such a comparison is not the point Bill is making. Maybe I’ve just missed it in his blog/comments, but I don’t think so.

      A change in NX always leads to changes in the other components of GDP, because the income flows and structure of production is changing.

      MMT argues that the government should deficit spend as this supplies profits (i.e. savings) to the private sector. This stimulates output (and can increase prices). Of course it also does much more — it shifts resources away from some and towards others within the private sector as well.

      But when looking at the current account, suddenly we all become Real Business Cycle theorists. Now, the loss of income and draining of savings to the foreign sector does not affect GDP at all. Each dollar spent on a foreign good is one dollar of income not available to domestic labor and domestic investment, at least in the NIPA sense. And this loss of income is assumed to have no effect on the economy because we will just suffer internal devaluation and deflation, and all the resources that were shed in the course of outsourcing will magically find other work — even though aggregate income has decreased.

      On the other hand, when looking at the effects on the exporter, Bill takes off the RBC hat and dons the Keynesian hat, arguing that the added export income is stimulative and leads to more growth and therefore more long term consumption. But when looking at the effects on the importer, the Keynesian Hat is removed, the RBC hat is put back on, and it is argued that the loss of wage income does not cause the U.S. GDP to change or consumption to decrease. Then, when arguing for government deficits, the RBC hat is again removed, the Keynsian hat is put on, and now the added income is stimulative.

      You cannot reason like this.

      To determine whether the imports increase or decrease consumption, you need to understand what effect they have on domestic incomes, relative prices, and changes to the structure of production.

      You can have economies of scale — e.g. two nations with 10 industries each benefit if they shed 5 industries and trade for the other 5 goods. In that case, falling unit costs mean that consumers still get 10 varieties but at a cheaper per unit cost, with more aggregate consumption for both — no trade deficit needed. Paul Krugman got the Nobel Prize for modeling this observation.

      You can have comparative advantage effects.

      It could happen that, for the net exporter, the additional income, combined with fewer goods, is all inflationary. But again, with downward sloping demand curves that will not be the case. It will only partially be the case.

      Simultaneous to that, domestic repression a la Asia can be used to prevent the export income from reaching the majority of households, in which case the income is used to increase the capital stock even further, leading to overcapacity and a profit glut in the government and corporate sector, while simultaneously creating domestic demand failures.

      That leads to debt bubbles and is deflationary, over the long term. This is the original “Dutch disease” — 150 years of stagnation as a result of massive external income injections in the 17th and 18th century.

      It all depends on the effects of the imbalance on the local economy, and this in turn depends on the form and terms of trade, together how these change the circulation of incomes within the private sector.

      In Korea, the additional export income was shared by both workers and capital investment, and consumption rapidly rose. The Koreans consumed more as a result of exporting.

      In Japan, the additional export income was primarily diverted to capital investment and not wages, and the economy was plunged into deflation. The Japanese consumed less.

      The two nations, although they exported similar goods on similar terms, had very different outcomes, because the institutional arrangements were different. Japan’s last major strike was in the 1970s, and median earning shares rapidly fell. Korea has a national strike ever other year, they indict their presidents for corruption, and median earnings, together with consumption, increased.

      Turning to the importer, it could be the case that an increase in the current account deficit, as with the iPhone example of rising chinese labor costs, leads to diminished income for capital, but not more or less consumption. Or it could be that an increase in the current account deficit, as when the production was shifted overseas, leads to increased capital income and decreased labor income, and less domestic consumption.

      But overall private sector income does decrease dollar for dollar with each net import — whether or not the stock of dollar assets geographically located in U.S. banks changes.

      It could be that, it is beneficial to be a slight net importer due to foreign capital inflows that are used to import capital goods. And that later on, it is beneficial to be a slight net exporter to export capital goods to other nations, so that they can acquire them and then develop their own industries.

      In all cases, it all depends on the type of trade. Are we losing increasing return industries, and replacing them with constant return or diminishing return industries?

      If so, then it must be the case that future consumption is lessened.

      A constant return to scale nation will consume less than a nation whose output has falling unit costs. Or, are we importing the capital goods necessary to generate our own increasing return industries? And who is receiving the external income?

      In all cases, you need to understand the effect of that surplus or deficit on the various actors within the private sector, and the long term ability of the private sector to both generate increasing return output and to get the wages and capital returns to the right hands so that there will be enough demand to buy that output.

      Looking at the current account wont give you enough information to decide whether something increases or decreases consumption.

    64. “Each dollar spent on a foreign good is one dollar of income not available to domestic labor and domestic investment, at least in the NIPA sense.”

      Each dollar spent on a foreign good is a dollar of income created for the exporting country.

      It is not a dollar of income “spent” by the importing country at the macro level.

      It is a dollar earned and saved by the exporting country and loaned to the importing country.

      The importing country is not spending from income at the macro level; it is spending from the liability it has created in the process of spending. That’s just a balance sheet transaction, like borrowing from a bank and spending. The exporter is just acting like a bank at the macro level.

      At least that’s the macro level accounting.

      Things in the mix may change, but not because importing country income is “spent” at the macro level.

      Seems consistent with the idea that imports are a real benefit.

      I suspect you’ll disagree with this, perhaps vehemently. Maybe you can tell me what’s wrong with it.

    65. “Each dollar spent on a foreign good is a dollar of income created for the exporting country.”

      No, goods flow in the opposite direction of incomes. You buy income with goods — goods do not create the income to buy them. You are articulating the Say’s Law view that supply creates its own demand. This view is why the standard models have all their income flows screwed up — they try to equate the goods flows with the income flows, rather than viewing two flows, one of income and the other of goods, that move in the opposite direction.

      Moreover, you are assuming that

      1) 100% of the current account is financed with the creation of new liabilities, not the transferal of existing financial assets from the domestic sector to the foreign sector. There is no reason to believe this, and if we look at what is happening, this is not what has been occurring.

      2) That when aggregate demand decrease, that output does not decrease, but that prices fall.

      By assumption, when China obtains $100 to from selling exports to the U.S., it rolls that money into the purchase of some domestic financial asset. Regardless of the geographic headquarters of the financial service provider, the asset belongs to China. By assumption, China will not use those assets to purchase U.S. goods — if it did, then the deficit would necessarily decrease. The key macro point here is not who owns the asset per se, or where the asset is located, but the decision to save (i.e. spend on the acquisition of financial assets) rather than to spend on goods. In order to maintain the imbalance, China must chose to save and not to spend.

      This process of saving is no different than if a U.S. households took a few hundred billion dollars of income and parked it in some asset, and chose not to spend, and repeated this every year. Such a decision would decrease output and consumption.

      All income circulates. Everyone who receives income must spend it on goods, and to the degree that they don’t, one of two things must happen. Either someone else in the economy must choose to deficit spend — e.g. spend in excess of their income — or aggregate output as whole must decline. That someone could be the government, or the foreign sector, but it must be someone. That follows from #2) being false.

      This is why you need your assumption #1) — that net new borrowing offsets the current account deficit. Without assumption #1, then the trade deficit subtracts from output.

    66. RSJ Thursday, June 24, 2010 at 12:02

      Assume for a moment the US economy is closed. Excess saving by households can cause an inventory recession with unemployment, thereby disproving Say’s Law.

      Assume that such a closed US economy is operating with a GDP level of X.

      Now assume the US imports dollar value Y from China. Assume no exports. So the current account deficit is Y.

      GDP is still X.

      At the macro level, the US pays for Y by borrowing from China.

      It makes no difference that this involves the “transfer of existing financial assets from the domestic sector to the foreign sector”. If the importer pays from an existing bank deposit, that deposit is effectively transferred from US ownership to Chinese ownership, even if the US bank of deposit changes (e.g. a PBOC deposit with the Fed). Notwithstanding that a US domestic asset has been transferred to the foreign sector, that asset now becomes a US liability in international accounting terms. It is a net foreign liability position for the US in its international accounts. And that liability represents borrowing from China in macro terms. It matters not whether China proceeds to exchange that deposit for Treasuries, corporate bonds, or equities. The position remains a net foreign liability for the US in international accounting terms.

      Furthermore, US income is not “spent” in the process of purchasing the import. The payment Y comes from a dollar deposit balance or dollar borrowing. That is a balance sheet transaction, quite separate from income accounting. US income is not “spent” on Y, because the dollar payment Y itself becomes the macro level liability issued in exchange for the import. It is a balance sheet transaction, not an income transaction, for the US.

      In fact, US income in its entirety has already been spent or saved as the offset to domestic production of X.

      Conversely, the marginal Chinese current account surplus does represent the value of Chinese output and is part of Chinese GDP and GDI.

      From a global perspective, the sum of all current account surpluses is a component of global GDP and global GDI.

      The sum of all current account deficits is NOT a subtraction from global GDI. If it were, the net effect of imbalances on global GDP would be zero, which is a contradiction. Therefore, any particular current account deficit is NOT a subtraction of income from the deficit country.

      From Say’s Law perspective, aggregate demand may fail in the open economy case due to the effect of the demand for imports on the demand for domestically produced goods. A domestic inventory recession can result in the same way that it can for the closed economy case. But in the macro sense, it won’t happen because income is being “spent” on imports. It will happen because the macro balance sheet effect of the current account deficit (i.e. increased leverage) will cause the US to want to save the income it has earned rather than spend it on domestic consumption. A domestic inventory recession may result.

      China saves through its current account surplus. This process is very different than the US saving against the backdrop of an assumed current account deficit (in this example).

      In China’s case, the macro saving effect is predetermined by the fact of its surplus. The surplus is a component of GDP. It is an expansion of GDP in that sense.

      In the US case, the macro saving effect is partially determined by the constraint of the assumed current account deficit in this example. The US is dissaving through its current account deficit. This does NOT mean the US is spending macro level income on its current account deficit. The opposite is the case. It is spending on output for which it has not earned income. It is spending via macro borrowing through its capital account surplus. That represents negative saving at the margin, which is one mode of dissaving. This marginal dissaving effect may create a headwind for domestic spending. Either the US spends to clear markets on its domestic output, or it saves (refrains from domestic spending) in an attempt to partially offset its current account dissaving. That’s another way of expressing the risk of a domestic inventory recession in the face of a current account deficit.

    67. Anon,

      Excellent presentation with your assumptions and hypothesis clearly and logically stated. I certainly benefited from your presentation. Unfortunately you are responding to a comment meant as an attack game rather than an argument a game shifting, circular in nature that actually ended with the assumptions! Typical RSJ!

    68. Anon,

      “Assume that such a closed US economy is operating with a GDP level of X.

      Now assume the US imports dollar value Y from China. Assume no exports. So the current account deficit is Y.

      GDP is still X.”

      The macro-accounting level tells you nothing about casualty, or the relationship between X and Y. You have no basis for assuming that an increase in net exports will leave domestic output unchanged. Just because there is an ex-post macro-decomposition does not imply that these variable are not constrained. They are all constrained by the requirement that foreign savings + domestic private savings + government savings = 0. A shift or increase in one of these is going to cause a shift in all the others, as well as a shift in domestic output.

      You are taking the ex-post macro-accounting decomposition, and turning into a behavioral relationship when you say that imports can increase from 0 to Y while leaving GDP unchanged.

      You cannot point at NX and say “we are consuming more then we otherwise would because of NX”. All you can claim is that we are consuming NX in addition to domestically produced output. I.e. — you are only allowed to describe the current situation, and cannot make any claims about the counterfactual.

      In order to make that claim, you need to believe that changes in NX move completely independently of changes in C, G, and I. In order to make that claim, you need some model of production and income flows.

      And to be even more picky, the statement “we are consuming more than we otherwise would because of NX” is itself undefined, because the actual value of NX ex-post will itself be determined by these income flows. Regardless of what a foreign nation desires to export, to the degree that those exports take market share away from domestic production, they reduce the wage and capital income of the target nation, which itself affects the level of NX that is obtained.

      So when running the counterfactual, it is better to say — what would the effect of a foreign sector intervention in its capital account be on U.S. NX, C, I, and G? In the immediate and longer term?

      The intervention will cause all these macro-aggregates to move. It may mean that C – NX increases, and it may mean that C-NX decreases, and the direction of movement can be different in the short and long runs. And the answer might be different if the shock was a rise in the foreign sector’s wage rates rather than foreign CB intervention in its capital account.

      But in order to say “imports are a benefit”, you need to run the counterfactual.

      In order to run the counterfactual, you need to have a model of production and consumption in order to estimate where the macro-aggregates would settle once the external change is made.

      Neither the rules of for determining the macro-accounting identities nor the current value of those identities are sufficient for running that counterfactual — you are giving these income measurement rules far too much power if you believe that they are.

    69. Anon,

      Didn’t mean to interrupt your conversation with RSJ. I somewhat agree with RSJ, though.

      In your GDP math, I think you are quite right. GDP is still X. However, in your scenario, you have changed something – increases in parameters describing borrowing. If you had created a scenario in which the payment was without borrowing but with what you already had – e.g., deposits in your bank, then the situation is almost similar but easier to think about. GDP is ~ production and even in that case, the GDP is still the same. GDP is C + I + G + X – M and both C and M have increased. so GDP is still the same. However, the receipt of your consumption has not gone to a domestic producer. In the next production cycle (which is actually continuous, but discretized for simplicity), the domestic producer will produce less. Another way of saying is that producers have an inventories to sales ratio and their production decisions depend on how well they are doing with this ratio. Hence in the next production period, the production will be lesser. Since production is investment in the economic sense and investment leads to saving etc., the wages paid in the next period is lesser. This reduces the income of households, and they will consume less in the next period because of lesser income. The GDP in the next period is thus reduced because of imports.

      Such processes are happening continuously and one has to see them that way and because of this, imports reduce aggregate demand unless there are other changes happening elsewhere such as the government relaxing its fiscal policy etc.

    70. Yes, Ramanan, we are in strange agreement in this case.

      Accounting only measures the current state of the system, but cost/benefit analysis requires trade-offs and counterfactuals. I can either do X or Y, and need to decide on what state the system will settle to if I do one or the other.

      The current values of NIPA will not tell you this.

      You need a model of production as well as consumer and firm decision making in order to determine the counterfactual.

      I think this is at the heart of many disagreements. Whether you are arguing that:

      * The sale of government debt enriches the households more than not selling debt (and creating money instead)
      * Tariffs/subsidies and import substitution policies increase or decrease consumption in the short and long term
      * Higher marginal tax rates reduce national income

      You need a model of production to run the counterfactual. You cannot just look at the current state of the system, and say that

      * $X of interest income is received by households, and therefore if bonds were to go away, households would be $X poorer
      * $X of net imports are purchased, and if the Tarrif were put in place, households would consume less.
      * $The increase in taxes directly impoverishes households

      etc.

      Whether or not you disagree or agree, the conclusion must be reached by running a model that accounts for the responses of the various actors to the change. This is why economists run models — they must do this. Even “empirical” econometric studies have at their heart some simple model that specifies a null hypothesis that is tested.

      But oftentimes in discussions here — particularly in relation to the supposed “welfare payments” of bond interest income, the opposite side is just looking at the current NIPA flows and subtracting or adding some variables, assuming the rest will remain unchanged.

      Then its “obvious” that a loss of bond interest income must decrease household sector net-worth because you just subtracted X from a balance sheet.

      But that is not an argument that you can make.

      The macro-balance sheets represent the final settlement value of the system in response to all of the stimuli. Change one stimuli — a tax rate, the existence of a financial instrument, or a tariff — and all the variables adjust and settle on a new value.

      That is the difference between micro and macro. In micro, you can tweak balance sheets that way, but in macro you cannot. At the macro level, the amount of income people have to buy the foreign car depends on the wages they earn from their domestic employer, which itself obtains its revenues from selling cars to its workforce.

      You have a closed system.

      The introduction of, say, cheaper foreign made cars will cause some revenue loss to the domestic producer, which results in wage and capital income decreases to the domestic population, and this also constrains the number of foreign cars that can be purchased. That will certainly affect investment and government deficit spending, which itself affects the other variables.

      All the sectors move together and settle on some new set of values.

    71. RSJ,

      “Yes, Ramanan, we are in strange agreement in this case.”

      I believe that if we discuss in a different way, we may agree on a lot of things.

      For example, you are correct to point out to shortcomings in arguments such as “The sale of government debt enriches the households more than not selling debt (and creating money instead)”

      I can easily construct an example where this may not be true – for example, after the first coupon turns up, household consume more and wages increase and more taxes are paid. The dynamic of the system can be fluctuating or may end up in a steady state. What if the coupon payments accelerate consumption and hence higher taxes and that finally the system ends up in a lower state of income than where it started ? How does one know ?

      Another example: when governments try to target their deficits, they run into an austerity mode and try to reduce their pure government expenditures. Higher coupons (interest rates) in such cases lead to lower income than the state where the system started out with.

    72. RSJ, Ramanan,

      If you notice the first three sentences in my comment, they are start out with the word “assume”.

      Then in my fourth sentence, I say “GDP is still X”.

      What I should have said is “Assume GDP is still X”.

      I omitted using that word for the fourth time in a row, I suppose because I thought the assumption of an assumption was self-evident in the flow of the recurring use of the word “assume”. But I should have included it a fourth time.

      Moreover, I thought it was self-evident due to the extreme simplicity of my example that I was not attempting to “model” a down and dirty counterfactual. I was trying to demonstrate quite a different point, and in doing so simplified the example as much as possible. I was trying to make the example as clean as possible and free of the very counterfactual dirtiness you were looking for.

      At the same time, there is no law of nature that prohibits the simplified concept of the counterfactual I did use. When I start out by asking you to assume the US economy is closed, it should be self-evident that I’m playing with some variables at the conceptual margin here, in as simplified a way as possible.

      Furthermore, if you look at the paragraph beginning “from Say’s Law perspective”, I thought it would be obvious that I was quite on board with the idea of real world counterfactual dirtiness, but that this wasn’t the main concern in my comment.

      The main concern in my comment was the demonstration of the correct accounting identities that must hold at all times.

      E.g. as RSJ says,

      “They are all constrained by the requirement that foreign savings + domestic private savings + government savings = 0.”

      My example holds to that identity. Net foreign saving has increased, and net private saving has decreased, due to the purchase of the import.

      All of this misses the point of what I was saying. If you reread the comment, and set aside your attack on my discretionary selection of the most simplified counterfactual possible, you might get that point. It’s largely about accounting for income coherently at the macro level, and calling note to a few claims that were made in a prior comment.

    73. Anon,

      My agreement with RSJ was only on one particular thing. Nothing about Say’s law etc.

      I probably misunderstood your points because of RSJ’s way of putting your points and just now saw your points properly.

      Goof. Apologies.

    74. Anon,

      I will be interested though in what you are getting at.

      When someone says “imports are benefits”, there is an implicit assumption of the government spending more than it should have. If a government doesn’t change its fiscal policy and the exports is constant, imports reduce GDP. In your example it may not have but as per your points on inventories, its likely the case that inventories are sold at a lesser pace if the import wasn’t done, which you have said in a different words.

      RSJ may have phrased an argument differently, which I to look at more carefully, but he is also asking that if the imports reduces aggregate demand, how can it be a benefit unless one assumes changes in other sectors.

    75. Ramanan,

      I haven’t argued anywhere that imports are a real benefit. That’s MMT. The accounting isn’t inconsistent with such an argument, but I haven’t made it. And I certainly haven’t argued anywhere that other things don’t change as a result of imports.

    76. Anon, the point is that to account for cost/benefit analysis “coherently” requires that you do not use the NIPA flows, but the actual income flows of individuals within the economy.

      I said that imports drain income from the private sector.

      You counter than no, from a NIPA macro-aggregate view, the imports are paid for by borrowing from the Chinese. The income flows from China to the U.S.

      I say that the goods flow from China to the U.S., and that the income flows in the other direction.

      I think we’ve had this dispute before.

      Operationally, we know that the flow of income is from the U.S. domestic borrower (really from the bank of the borrower) to the Chinese lender. These are funds that could have been — in the counterfactual — used to purchase domestic output.

      The decision to purchase the foreign goods represents a loss of income for the domestic sector — actual income of economic actors.

      NIPA does not try to measure actual income.

      NIPA tries to measure something different — namely total domestic output, and therefore it must subtract out spending on foreign goods.

      As a result NIPA defines national income by what is purchased, not who does the purchasing.

      That is both operationally misleading, as it hides the trade-off that the domestic sector faces between spending on foreign or domestic output. It hides aggregate demand, and all demand leakages.

      It is not more “correct” or “coherent” than just looking at the actual incomes of private sector actors.

      And in terms of analyzing the counterfactual, and talking about benefits or costs of net imports, you need to measure income by who does the purchasing. You want standard accounting as in the flow of funds, rather than NIPA’s Gross Domestic Income.

      That will give you the true measure of aggregate demand, and then the trade-off between income spent on domestic rather than foreign output becomes clear.

    77. Ramanan,

      And for my part, I also emphasized that whether imports were a cost or benefit will be determined by the effect of the import on the domestic economy, and I tried to give examples in which an increase in the trade deficit represented both a benefit and a cost, depending on what was happening.

      In general, though, I tend to view any long run imbalance as harmful, whether that would be a persistent surplus or a persistent deficit. Over long time periods, the best trade is balanced trade, and the purpose of non-convertible floating currencies is to drive the imbalance to zero.

    78. Anon,

      I commented on your clear presentation because you obviously try to share your hypothesis based on well defined assumptions and accounting principles. Ramanan, who is a civilized blog participant admitted his misunderstanding of your position twisted by the other game player whose main purpose is not to understand what you say and reach a consensus, since your main positions about the “benefit” and the demand drain are not different, but to score points. By the way, many times when forced he presents reasoned positions that we can learn from. We are discussing in this blog in order to understand, discover and share ideas and not to attack each other. It makes more sense to ask questions, give the benefit of the doubt and state a clear hypothesis upon which we can debate constructively rather than to talk across purposes with counterfactuals. The question is, ARE WE LISTENING OR ONLY TALKING?

    79. Yes – flexible exchange rates seem to have the flexibility to reduce imbalances. In the gold standard and fixed exchange rate regimes, there is none and the Mundell-Fleming doesn’t apply.

      My point is that even if the finance ministry and the central bankers make an effort to understand the behaviour of monetary financial system, they will always have a bias on the austerity side. They will always curb domestic demand and give into the export lobby because of the scars from the past – the loss of foreign currency and rapid movements of exchange rates. Exchange rates can move even if speculative action is banned because someone has to be ready in the international currency markets to accept currency.

      Rapid exchange rate movements can be very painful. It takes some time for the demand for imports to adjust. That is the quantity adjustment does not change in response to a price change and the immediate effect of a plunge in exchange rates is the deterioration of the the balance of payments.

      One solution is for all governments to take concerted action and the exchange rate folks don’t know where to move because all parties are doing the “sin”.

    80. Ramanan,

      I missed reading your comments regarding the balance of payments issues which I find very instructive. Also your comment regarding the shorting mechanism and procedures was very detailed and knowledgable regarding the arrangements involved. It is good to have discussion and comments from fellow bloggers that know the details and can explain them clearly. I assumed people knew these details but obviously some do not.

    81. RSJ (Friday, June 25, 2010 at 8:09),

      There are three “standard” types of accounts in double entry bookkeeping – income statements, balance sheets, and flow of funds. This system of accounts holds at micro and macro levels.

      At the micro level, flow of funds is usually referred to as sources and uses of funds. NIPA is the macro correspondent to micro income statements.

      “You want standard accounting as in the flow of funds, rather than NIPA’s Gross Domestic Income.”

      Flow of funds accounting is no more or less standard that income statement and balance sheet accounting. All three are part of and essential to a complete system of financial accounts for micro and macro. Each conveys a unique perspective on economic and financial activity at those levels. And as a set of accounts they are internally consistent and interdependent.

      “I say that the goods flow from China to the U.S., and that the income flows in the other direction.”

      Obviously goods flow from China to the U.S.

      But income does not flow from the US to China.

      The US outward flow is an expenditure flow. It will appear on US micro and macro income statements as such. Not only is that flow not income, it does not require income. As noted earlier, at the macro level, the source of funds in income statement terms is not US income, but Chinese income.

      The Chinese inward flow is an income flow. It will appear on Chinese micro and macro income statements as revenue or gross income. In the case of a current account surplus, it will generate an equivalent level of saving from income in the Chinese version of NIPA statements.

      Thus, is no “flow of income” from the US to China. There is an expenditure for the US and income for China. And the US expenditure is not matched by US income.

      The US earns income from its GDP. Income flows from US production to the domestic factors of production. It does not flow back to producers. That’s an expenditure flow.

      In particular, US domestically generated income does not flow to China. The purchase of Chinese goods is an expenditure flow. It also happens to be dissaving at the margin of the current account deficit, because the US is spending more than it has earned from its income.

      Not only is US income not flowing to China, but at the macro level the expenditure in question has no US income offset. That’s why the US borrows at the macro level as a result of its current account deficit. So it’s pretty wildly misleading to claim that income flows from the US to China.

      “Operationally, we know that the flow of income is from the U.S. domestic borrower (really from the bank of the borrower) to the Chinese lender. These are funds that could have been — in the counterfactual — used to purchase domestic output. The decision to purchase the foreign goods represents a loss of income for the domestic sector — actual income of economic actors.”

      It is not an “operational” flow of income. It is expenditure. The accounting distinction between income and expenditure is fundamental. The suggestion that a single accounting entity (e.g. the US) produces income flows in polar opposite directions represents a fundamental confusion of flow of funds accounting and income statement accounting.

      “NIPA does not try to measure actual income. NIPA tries to measure something different — namely total domestic output, and therefore it must subtract out spending on foreign goods. As a result NIPA defines national income by what is purchased, not who does the purchasing.”

      NIPA measures output via GDP and income via GDI. It defines national income properly as a flow of value from production to the factors of production.

      Finally, as a separate point of accounting logic, imports are not subtracted “from GDP”.

      GDP = C + I + G + (X – M)
      = (C + I + G + X) – M
      = (GDP + M) – M
      = GDI

      GDP is derived by subtracting imports from a comingled expenditure expression that includes the direct and embedded value of imports. Because GDP does not include imports, and because GDP equals GDI, GDI does not include the income required to cover imports. So macro level income does not “flow” to the purchase of imports. The related income flow is found and begins only on the exporter side of the equation.

    82. meant in final paragraph above:

      Because GDP does not include imports, and because GDP equals GDI, GDI does not include the income required to cover imports at the margin (e.g. current account deficit). So macro level income does not “flow” to the purchase of imports at the margin. The related income flow is found and begins only on the exporter side of the equation.

    83. Panayotis,

      Thanks for the nice words. My interest in the external sector has been through Basil Moore’s book Shaking The Invisible Hand. He discusses a lot of nice points on exchange rates and the behaviour of central banks and governments because of the complication arising out of the external sector and the implications for employment.

    84. Anon,

      “NIPA is the macro correspondent to micro income statements.”

      No, NIPA measures final output.

      A micro-income statement will contain income from the sale of goods, from transfers (e.g. subsidies), as well as income from financing.

      When only allowing for national income to be viewed as GDI, you are explicitly excluding income from the sale of financial assets.

      NIPA does not measure this income, but flow of funds does.

      Now, not every macro-aggregate needs to include everything — the measurement comes with a scope of what is measured. That’s fine, but when measuring the total income of the domestic sector, you need to measure income from all sources.

      That income is then used to purchase a combination of domestic output, foreign output, and domestic and foreign financial assets.

      Depending on the scope of your balance sheet — in our case, the entire domestic sector (e.g. government and domestic private sector) — there will be a discrepancy between income from the sale of domestic output and expenditures on the sum of domestic and foreign output. That residual will be measured in changes to the capital account.

      Nevertheless, despite this aggregation and netting process, all sources of income are available for all uses.

      At the level of each actor — each micro-balance sheet — income from the sale of financial assets can used to fund the purchase of foreign goods, domestic goods, or domestic financial assets.

      I can take out a loan and buy a domestic car or a foreign car. My income is increased by the loan. My income does not come from China. But how much of my income is received by China (and lost to GDI) ex-post will be a function of my decision.

      The actual values of GDI and the current account will then reflect the result of all of those trade-offs.

      Ex-post, it may appear as if China is lending to the U.S., but we know that ex-ante, the domestic sector is generating its own income endogenously — the source of funds has an endogenous credit creation component — and the use of those funds goes to purchase some combination of domestic and foreign output. It is not necessarily a 1-1 trade off, and the results may be different over the short and long runs.

      Nevertheless, the NIPA aggregates — precisely because they consolidate micro-balance sheets and exclude income from financing — hide this trade-off, and make it appear as if the domestic sector did not have the income necessary to buy the foreign output, unless the foreign sector supplied it with that income.

    85. RSJ, Saturday, June 26, 2010 at 9:38

      ““NIPA is the macro correspondent to micro income statements.” No, NIPA measures final output.”

      NIPA is the basis for calculations of both GDP and GDI. The ‘I’ in NIPA is income. The ‘I’ in GDI is income. GDI is the macro version of an income statement.

      “When only allowing for national income to be viewed as GDI, you are explicitly excluding income from the sale of financial assets. NIPA does not measure this income, but flow of funds does.”

      The sale of financial assets does not constitute income. This is accounting 101. The financial asset appears in the flow of funds statement as a flow, and in the balance sheet as a stock. It does not appear in the income statement.

      “I can take out a loan and buy a domestic car or a foreign car. My income is increased by the loan.”

      The creation of a loan does not constitute income. Again, this is accounting 101. The loan appears in the flow of funds statement as a flow, and in the balance sheet as a stock. It does not appear in the income statement.

      By all means, analyse the effect of loans and financial assets on economic activity, but there’s really no need to violate basic accounting definitions and logic in doing so. You can explain anything you want in economics while respecting normal accounting integrity. Conversely, you’ll get stuck in a morass of internal inconsistency if you arbitrarily redefine accounting terms to fit your economic story. The various accounting definitions are designed to be mutually consistent, and when you violate the use of one of the pieces, the entire framework is disabled for further use in any coherent discourse. What surprises me is that you’ve had odd blog conversation with Scott Fullwiler, who is quite an expert on macro accounting. I would have thought he’d have pointed out this sort of thing to you by now. And given MMT’s core emphasis on accounting integrity, I would have also thought Bill Mitchell might have mentioned it as well.

      Again, you don’t need to try and revolutionize the rudiments of double entry bookkeeping or reorganize universally understood accounting logic in order to develop your economic arguments. If you’re unable to make a point using normal accounting connections, then you probably don’t understand the point you’re attempting to make. For my part, I don’t really spend a lot of time analysing arguments that violate generally understood accounting definitions and interconnections. Indeed, virtually all of my comments on this thread are about trying to avoid that situation.

      There shouldn’t be anything preventing you from developing your arguments on the basis of a clear delineation between income statements, balance sheets, and flow of funds accounting elements. I would encourage you to do this, because your arguments will probably end up stronger as a result.

    86. While Anon’s accounting is flawless and impeccable, I think RSJ’s point is talking of a different time horizon, a sort of a medium term analysis. Income = Expenditure globally and the quantities are defined so that they satisfy the identity. RSJ is saying that they feed into one another and the causality is both ways and in the medium term it will lead to a reduction of income of the United States.

    87. “Problems are greatly compounded if the nation has issued foreign-currency denominated debt. If this debt is issued by private firms (or households), then they must earn foreign currency (or borrow it) to service debt. To meet these needs they can export, attract FDI, and/or engage in short-term borrowing. If none of these are sufficient, default becomes necessary”

      this statement has raised my curiosity,

      our banks source financing from overseas financial markets. can someone explain to me if their foreign liabilities are denominated in the source country currency and then converted to oz dollars for domestic use. so are there liabilities held in off shore accounts of the country of source as a foreign currency loan by our banks.

      i am trying to get a better understanding of the detailed mechanics of how banks obtain offshore funding, if any one can enlighten me, or point to some links of use , that would be much appreciated. it would be great to know the accounting structure involved.

      the reason iam interested , is that while national governments sovereign in their own currency may have no financing problem, banks with large foreign currency denominated borrowing do, and i am curious how a national government would deal with a situation of a bank default in this regard.

      i suppose the key is that a national government can provide domestic funding to a bank , which then can be converted into foreign currency to meet any foreign liabilities, as long as the currency remains internationally convertible. am i right or wrong

      i would like to know from bill and others, what sort of vulnerability australia faces from australian banks holding such large foreign currency denominated liabilities.

      a blog post perhaps

    88. Ramanan,

      The long term does not cure the abuse of accounting definitions and logic in the short term. US Income may decline because of a decline in aggregate domestic demand, but it does not decline because current income is “transferred” from the US to China. By all means, analyze aggregate demand and its effect on income, but don’t jam it up with faulty accounting analysis and abuses of both economic and accounting terminology.

      BTW, there is no such thing as negative income in economics or in the macro accounting framework that measures economics. And there is no such thing as negative (gross) investment. However, there is such a thing as negative saving for any sub-global unit. Negative saving gets reflected in micro income statements through such items as “losses” in the case of corporations. Negative saving flows through to a reduction in balance sheet net worth. But it is not negative income. These aspects are a source of much of the accounting confusion.

    89. Anon,

      My comment was merely meant to try to put forward what RSJ was trying to say. He wasn’t correct in the loans creating income part but the fact is that unless the fiscal policy is changed, imports put a downward pressure on national income.

      Yes there is no such thing as negative income in national accounts. However there are dynamics because of imports which lead to reduction of aggregate demand. This can be established by solid accounting models where every stock and every flow is taken into account and where the definitions used are consistent with national accounts. Aggregate demand declines because of various factors and one important factor is the “transfer” from the US to China.

      In a simple transaction it doesn’t look like, but there are feedbacks which need to be taken into account such as lesser production in the next period and hence lesser income for the domestic economy. Of course there is no meaning about “lesser income” etc but neither do national accounts say anything about the future. I can use the national accounts to make some projections but that is a different matter.

      An example for a dynamic accounting model: Assume that the economy can be divided into various sectors such as households, firms, (no banks), central bank, and the government. If the government spending in each period is G and the tax rate on national income is θ, the “steady state” GDP is G/θ – a surprisingly a bit independent of the household propensities to consume. Those parameters make an appearance in the household wealth and other numbers.

      If you include two economies, the steady state GDP is (G+X)/(θ+µ) where µ is the propensity to import, i.e., Imports = µGDP
      If the propensity to import increases the steady state GDP decreases. (X is the exports in one period). These accounting models are courtesy the late Wynne Godley and stock flow consistency is his baby.

      Of course simple models (and complicated ones exist too), but are the only ones around respecting accounting.

      So to your point about transfers – yes the transfer to China reduces national income – not immediately but because of processes that are likely to occur in the future. It’s accounting consistent to say that imports reduce aggregate demand.

      In your example, the person importing took a bank loan to import and pay the Chinese. He has to forgo some consumption in domestically produced goods because his income is not unlimited. The producers then produce less in the next period and hence less income is paid out to the household sector. Of course, the future is not so predictable but that doesn’t discourage anyone to make sense of how the economy works by modeling and what are the implications of various economic activities.

      James Tobin said this the best

      The accounting identities equating aggregate expenditures to production and of both to incomes at market prices are inescapable, no matter which variety of Keynesian or classical economics you espouse. I tell students that respect for identities is the first piece of wisdom that distinguishes economists from others who expiate on economics. The second? … Identities say nothing about causation.

    90. Should be
      “. . . doesn’t discourage anyone to make sense of how the economy works by modeling and figure out what the implications are of the various economic activities.”

    91. Ramanan,

      Splendid comment.

      “However there are dynamics because of imports which lead to reduction of aggregate demand. This can be established by solid accounting models where every stock and every flow is taken into account and where the definitions used are consistent with national accounts. Aggregate demand declines because of various factors and one important factor is the “transfer” from the US to China.”

      Yes. Keep writing in these terms. But be clear on the causation – aggregate demand to income. Not income to income.

      “It’s accounting consistent to say that imports reduce aggregate demand.”

      It’s consistent to say that imports reduce aggregate demand, but it’s not accounting consistent if you make erroneous statements about accounting along the way, which has been the case from some.

      Tobin was on the right track, but misses the mark:

      “I tell students that respect for identities is the first piece of wisdom that distinguishes economists from others who expiate on economics. The second? … Identities say nothing about causation.”

      First, the mere existence of MMT is proof that most economists don’t understand central bank accounting, and many don’t seem to understand the logical implications of the sector financial balances identity.

      Second, and more important, identities are necessary, but not sufficient, to understanding causation.

      Tobin missed the necessary part.

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