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Yuan appreciation – just another sideshow

The attacks on the use of fiscal policy to stabilise the domestic economies of nations that are still languishing in the aftermath of the financial crisis has moved to a new dimension – a escalation in the attack on China and its stupid policy of managing its currency’s exchange rate. The debate is interesting because it is in fact a reprise of discussions that raged in previous historical periods. Each time there is a prolonged recession, governments start suggesting that the problem lies in the conduct of other governments. There is a call for increasing protection (“trade wars”) or demands for some currency or another to appreciate (“currency wars”). The prolonged recession is always the result of the governments failing to use their fiscal capacity to maintain strong aggregate demand in the face of a collapse in private spending. Typically, this failure reflects the fact that the governments succumb to political from the conservatives and either don’t expand fiscal policy enough or prematurely reign in the fiscal expansion. These episodes have repeatedly occurred in history. And at times, when some “offending” governments have been bullied into a currency appreciation (for example) the desired effects are not realised and a host of unintended and undesirable outcomes emerge. This debate is another example of the way mainstream economics steers the policy debate down dead-ends and constrains governments from actually implementing effective interventions that generate jobs and get their economies back on the path of stable growth. So the yuan appreciation debate – just another sideshow. I wonder why we bother.

Heading off a “currency-war” and the threat of increasing trade protection appears to be the main topic at the Washington meeting convened by the IMF, the World Bank and the Group of 20.

The US Treasury Secretary told an audience at the Brookings Institution this week (October 6, 2010) as a political posturing exercise leading up to the Washington meeting that the:

…. greatest risk to the world economy today is that the largest economies underachieve on growth … [and] … as America saves more, countries overly reliant on exports to us for their own growth will need to change their policies, or else global growth will slow and all of us will be worse off. Countries that chronically run large surpluses need to undertake policies that will boost their domestic demand … [and] … it is very important to see more progress by the major emerging economies to more flexible, more market-oriented exchange rate systems. This is particularly important for those countries whose currencies are significantly undervalued. This is a problem because when large economies with undervalued exchange rates act to keep the currency from appreciating, that encourages other countries to do the same.

So China – appreciate your currency!

The IMF has also joined the “Bash China” chorus. Its chief economist at a Press Briefing on the IMFs World Economic Outlook (October 6, 2010) said in this

Many emerging countries, here most notably China, had relied excessively on net exports before the crisis and must now turn more to domestic demand. These readjustments are essential to maintaining a strong and balanced recovery … What is needed for external rebalancing is a fairly general appreciation of emerging market country currencies relative to advanced country currencies. .

The Chinese have retorted that:

If the yuan isn’t stable, it will bring disaster to China and the world … If we increase the yuan by 20 percent-40 percent as some people are calling for, many of our factories will shut down and society will be in turmoil. If China’s economy goes down, it’s not good for the world economy.

So clearly the Chinese think that an appreciation would damage their trade prospects.

In the UK Guardian (October 6, 2010) – known “progressive” economist Dean Baker waded in on the issue in his article – Economics 101 for deficit hawks. I actually hope the deficit hawks don’t read this article because I would not hold it out as a very accurate lesson for them.

Dean has grasped that the sectoral balances are indeed a powerful framework for organising one’s understanding of the way the economy works. He says:

There are few areas of economics more boring than accounting identities. This is really unfortunate, since it is virtually impossible to have a clear understanding of economic policy without a solid knowledge of the underlying identities.

Most of the people in Washington policy debates were apparently overcome by boredom before they could get this knowledge. As a result, we see some really silly policy debates.

The debate over the value of the dollar against the Chinese yuan is the latest episode in this silliness. The Washington tribal elite has been on the warpath against budget deficits in recent months. They have worked themselves into such a frenzy that nothing will stand in their way: neither concerns about unemployment, nor concerns about the well being of our elderly, nor even concerns about basic economic logic.

I completely agree that the debate about the Chinese currency is out of control. Most commentators have not thought through the implications of their demands, understood the underlying relationships that are involved and considered history. Most of the commentary is at the level of the first-year text book which is bound to lead to erroneous conclusions.

Baker then says by way of 101 instruction that:

The central problem stems from the simple accounting identity that national savings is equal to the broadly measured trade surplus. A country with a large trade surplus will also have large national savings. Conversely, a country with a large trade deficit will have negative national savings. These relationships are accounting identities – there is no way around them.

Well this is not what I would want a deficit terrorist to learn. Please read my blog – Twin deficits – another mainstream myth – for a derivation of the sectoral balances and more background material.

The sectoral balances are:

(T – G) = budget balance, where T is tax revenue and G is government spending.

(S – I) = private domestic balance, where S is total private saving and I is total private investment.

(X – M) = external (trade) balance, where X is total exports and M is total imports.

If (T – G) > 0 then there is a drain on aggregate demand via the public sector. If (S – I) > 0, then the private domestic sector is saving overall and this creates a drain on aggregate demand. If (X – M) > 0, then net exports are positive and this would add to aggregate demand via the foreign sector.

Further, by implication, external deficits drain aggregate demand from the economy and budget deficits add aggregate demand.

These balances are linked via a strict accounting relationship which is derived from the National Accounting framework such that:

(S – I) + (T – G) – (X – M) = 0

The following graph and associated data table shows you the relationships between the government balance and the private domestic balance when there is a constant external deficit.

You can then manipulate these balances in many ways to tell stories about what is going on in a country.

One way of writing the balances to show the relationship between the government and the non-government sectors:

(G – T) = (S – I) – (X – M)

That is a government deficit (G – T > 0) has to be associated with a non-government surplus, which can be distributed between the private domestic balance and the trade balance.

If there is a trade deficit (X – M < 0) then (S - I) has to be negative (that is, the private domestic sector is spending more than it is earning) if the government budget is in surplus (G - T < 0). That is clear from the graph (see Periods 5 to 7). Another way to "view" the sectoral balances is to express the external position against the domestic position: (X - M) = (S - I) - (G - T) which is the way that Baker wants the readers to be thinking. So if there is an external surplus (X - M > 0), then the right hand side also has to be in surplus. So if the budget was balanced (G – T = 0) then the private domestic sector would carry that surplus (S – I > 0).

The problem with Baker’s depiction of this is that he constructs a budget surplus as “national saving”. In this regard (and I am skipping ahead in his argument) he says:

This brings us back to the budget deficit part of the story. If the United States has a large trade deficit, then it means that net national savings are negative. That is definitional. For net national savings to be negative, then we must have either negative private savings or negative public savings (that is, a budget deficit).

Modern Monetary Theory (MMT) does not construct the relationships in this way. It makes no sense to call a budget surplus a contribution to “national saving”. The conceptualisation of the budget balance runs deep in mainstream macroeconomics and is ultimately at the heart of the loanable funds doctrine and the erroneous theories of financial crowding out. It is also a central implication of the false household-government budget analogy that is at the core of the mainstream approach.

No progressive should use this terminology or depiction.

To see why it is an erroneous description of the monetary implications of a sovereign government running a budget surplus think about what saving means to a household.

When individuals (households) save they postpone current consumption because they want to have higher future consumption. Saving is a time machine for non-government entities to allow them to transfer consumption across time. The obvious motivation is that they face a budget constraint – as users of the currency – and have to forgoe consumption now if they want to save.

For the monopoly issuer of the currency – the sovereign government – there is no such financial constraint on spending. It does not have to forgoe spending now to spend in the future. It can always spend what it desires at any point in time irrespective of what it did last period or any previous periods.

Further, when the government runs a budget surplus the purchasing power it extracts from the non-government sector doesn’t go anywhere – it is not stored in any account to use for later purposes. Just as a budget deficit (excess of spending over tax revenue) creates net financial assets (in the currency of issue) a budget surplus destroys net financial assets.

There is no store of purchasing power when the government runs a surplus nor does it make any sense for a government to think in those terms. It can always spend what it likes.

So it is nonsensical to characterise a budget surplus as being “saving”. It is more correctly described as the destruction of non-government purchasing power and non-government net financial assets (wealth).

Once you think of budget surpluses as “national saving” in an analogous way to private saving you are sliding into the slippery and false world of the theory of loanable funds, which is a aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking. The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.

In Mankiw’s macroeconomics textbook, which is representative, we are taken back in time, to the theories that were prevalent before being destroyed by the intellectual advances provided in Keynes’ General Theory.

Mankiw assumes that it is reasonable to represent the financial system as the “market for loanable funds” where “all savers go to this market to deposit their savings, and all borrowers go to this market to get their loans. In this market, there is one interest rate, which is both the return to saving and the cost of borrowing.”

So in the theoretical classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times, when consumption fell, saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving. Public surpluses are just another source of “saving” in this model.

So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.

In this mythical market for loanable funds, the real interest rate adjusts to ensure that the supply (national saving) of loanable funds and demand (investment) for loanable funds is always equal. The supply of funds comes from those people who have some extra income they want to save and lend out and in this conception public surpluses. The demand for funds comes from households and firms who wish to borrow to invest (houses, factories, equipment etc). The interest rate is the price of the loan and the return on savings and thus the supply and demand curves (lines) take the shape they do.

Mankiw says that the “supply of loanable funds comes from national saving including both private saving and public saving.” Think about that for a moment. Clearly private saving is stockpiled in financial assets somewhere in the system – maybe it remains in bank deposits maybe not. But it can be drawn down at some future point for consumption purposes.

Mankiw thinks that budget surpluses are akin to this. As noted above – budget surpluses are not even remotely like private saving. You should clearly understand by now that budget surpluses destroy liquidity in the non-government sector (by destroying net financial assets held by that sector). They squeeze the capacity of the non-government sector to spend and save. If there are no other behavioural changes in the economy to accompany the pursuit of budget surpluses, then as we will explain soon, income adjustments (as aggregate demand falls) wipe out non-government saving.

Please read my blog – Budget deficits do not cause higher interest rates – to see why “progressive” Dean Baker is sitting in the same camp on this issue as the conservative neo-liberal economists like Elmendorf (US CBO director) and Mankiw (Harvard right-winger).

Baker’s main point is that for the US:

At a given level of GDP, the main determinant of the trade deficit is the value of the dollar in international currency markets. This is very basic supply and demand. If the dollar is higher in value relative to other currencies, then our exports will cost more to people living in Germany, Japan, and China.

So to fix the deficit with China he clearly thinks the Chinese have to appreciate its currency.

I wonder what happened between mid-2005 and late 2008, when the Chinese government allowed the Yuan to appreciate by nearly 20 per cent against a trade weighted basket of currencies (their main trading partners). Over this period, the bi-lateral trade balance between China and the US grew from $US205 billion in 2005 to $US268 billion in 2008. I will come back to this at the end.

As we will see later, the “Bash China” movement is a reprise of the “Bash Japan” movement in the 1980s and that led to undesirable consequences.

Baker also says after noting that as a result of the collapse “people are now saving much more” and “investment has fallen due to overbuilding” so that “private-sector savings are no longer negative”:

This leaves us with our large budget deficit. The budget deficit follows from the fact that we have a trade deficit, which is, in turn, the result of the over-valued dollar.

The implied causality would lead you think that the trade deficit is “causing” the budget deficit. The correct way of thinking is that the two must co-exist if the private domestic balance is in surplus. Why?

If we start from a given external deficit (X – M < 0) and the private domestic sector was in deficit (S - I < 0) then the public balance could be in surplus (see Periods 5 to 7 in the graph) and economic growth could continue. But the private domestic sector would be increasingly accumulating debt and this growth strategy would be unsustainable. So there is nothing inevitable about a trade deficit being associated with a budget deficit as is shown in the scenarios modelled in the above graph. It all depends on what the private sector spending and saving decisions are. The way to think about it is that the budget deficit is endogenous (that is, responds to the spending decisions of the private domestic sector). This is because the budget outcome is, in part, a result of the automatic stabilisers which respond to changes in the level of economic activity which is driven by private sector spending and saving decisions (as is the external balance). Thus, if we move from this situation (private deficit) to a situation where the private domestic sector is spending less than they are earning (S - I > 0) and the external sector remains in deficit (X – M < 0) then the combined outcomes drain aggregate demand and promote a decline in real output and national income. Without any discretionary change in fiscal policy the income adjustments will drive the budget balance into deficit (via the automatic stabilisers) - see the transition from Period 3 then 2 then 1 in the above graph. Obviously, if the government expands its discretionary fiscal position (a rising deficit), it can drive the private sector into a net saving position fairly quickly and maintain economic growth. This may also expand the external deficit (via rising import spending) but doesn't necessarily have to. It would all depend on the spending and saving decisions of the private domestic sector. Baker then attacks the conservatives who:

… routinely express horror over the size of the budget deficit … [but] … anyone who hopes to get the trade deficit down must recognize the need to lower the value of the dollar. And, if one wants to get the budget deficit down, then it is necessary to reduce the trade deficit.

But again this doesn’t necessarily follow. A lower value of the dollar may help improve the trade position. This depends on the trade elasticities and relative inflation rates, which in turn, reflects relative productivity growth rates. The responsiveness of the trade balance to nominal exchange rate movements is not unambiguous.

However, the second statement “to get the budget deficit down … it is necessary to reduce the trade deficit” is a false statement. It depends on what you want to achieve. The correct statement is that if you want the private domestic sector to keep saving and running down its precarious debt levels and you want to maintain economic growth in output and income, then the larger is the drain on aggregate demand coming from the external sector, the larger the budget deficit has to be.

You can desire to expand exports faster than imports and thus reduce the external drain on aggregate demand, but then if the private sector is saving or in balance, the budget will still have to be in deficit until net exports become positive and exceed the drain on aggregate demand arising from the private domestic balance.

Clearly, the IMF and other bodies are pushing for export-led growth strategies as part of their pressure to reduce budget deficits. But this

Please read my blogs – Export-led growth strategies will fail and Fiscal austerity – the newest fallacy of composition– for more discussion on this point.

The other way of approaching the problem is to reduce the import propensity (that is, reduce the percentage of each new dollar of national income that goes to imports). The “Buy Australia” or “Buy America” type programs try to achieve this aim. In a world of multi-national capitalism these measures are not effective. Patriotism only goes so far when it comes to people making decisions in shops or on-line as to what they purchase and why.

Back to the 1980s

We should also not forget that the Americans have been through this rhetoric in the past. During the recession of the early 1980s, it was fear of Japan and the NICs (South Korea, Singapore, Hong Kong and Taiwan). Today it is China and India. In particular, Japan was the bogey country causing imbalances in world trade and preventing the US and other “trade deficit” countries from growing.

In the early 1980s, for example, the former US Vice President, Walter Mondale, who at the time was lobbying to become the 1984 Democratic Presidential nomination told the New York Times (October 13, 1983) that:

We’ve been running up the white flag when we should be running up the American flag … What do we want our kids to do? Sweep up around the Japanese computers?”

I cover some of the history of this period and debate in this blog – What you consume or what you produce? and noted that after rehearsing a vehement protectionist stance, Walter Mondale eventually became the US Ambassador to Japan in the Clinton Administration and was full of praise for them. But during the recession of the early 1980s, he was leading the calls for protection against the Japanese.

But during the recession of the early 1980s, many US factories closed because they could not (allegedly) compete against the new manufacturing strength of Japan and north-east Asia.

In the 1970s and 1980s, Japan was the fasted growing advanced nation and its manufacturing innovations allowed it to become an export powerhouse. All the claims now being made about China’s “overvalued” currency were made against Japan in the 1980s. Japan ran large trade surpluses with the US and the latter started to place extreme political pressure on Japan to allow the Yen to appreciate in value. It was stated often during that period that if only the Yen would appreciate then the US current account deficit would be reduced and its prospects for growth would be solid.

The history of the yen is actually interesting and in the post World War 2 era reflects a lot of US meddling. The abandonment of the Bretton Woods agreement in 1971 by the US (President Tricky Nixon) was in no small part due to the large current account deficits the US were running against Japan. The US believed then – just another historical reprise of the current debate – that the currencies of their main trading partners were undervalued.

Interestingly, immediately after the US devalued in mid 1971, they negotiated (in December 1971) the Smithsonian Agreement which was an attempt to get several nations to revalue their currencies and re-establish the fixed exchange rate regime abandoned earlier that year. The agreement wasn’t sustainable given the changes in the underlying trade fundamentals that had brought the system down in the first place and it was abandoned in March 1973.

At that point, most currencies floated (hallelujah!) although the Japanese government was under intense domestic pressure to prevent the currency from appreciating because local firms etc did not want a return to the large external deficits of the 1960s (yes, they were misguided in thinking that high-priced imports that they were barely able to afford was a good thing). So Japan never really floated freely in this period.

While the Yen did appreciate somewhat during the rest of the 1970s, the two oil shocks really damaged its economy and pushed the Yen down so by the early 1980s, with export surpluses returning, there was a claim that the currency was undervalued.

As the trade surpluses grew, there was clearly strong Yen demand in international currency markets but there were offsetting factors which prevented it from rising in value consistent with the growing surpluses. Some of these offsetting factors were controlled by the US – for example, the higher US policy interest rates. US Federal Reserve boss Paul Volcker was the architect of that policy!

Ironically, at that time the IMF were trying to assert their neo-liberal stamp on world governments and together with its biggest “shareholder” (the US government) they pushed heavily for deregulation of capital flows between countries.

As the restrictions on international capital mobility were relaxed, the large surpluses Japan had been accumulating courtesy of their trade strength manifested in large outflows on the Capital Account of its Balance of Payments as the Japanese pursued asset building opportunities in other currencies. These net outflows thus reduced the excess demand for the Yen in the foreign-exchange markets and that was the main reason the Yen didn’t appreciate despite the growing trade surpluses.

Enter the so-called Plaza Accord in September 1985 where of senior officials from France, Japan, West Germany, the US and the UK met and agreed to depreciate the US dollar against the Yen and the German Mark. The central banks would engage in official intervention in foreign-exchange markets to ensure the currencies moved in the direction outlined in the Accord.

History tells us that the depreciation of the US dollar against the Yen, while it made US manufactured goods cheaper in world markets did not fundamentally alter the trade balance against Japan.

The following graph shows the evolution of the Japanese trade balance (blue bars) with the US from 1980 to 2005 and it Yen/USD parity (red line) over the same period. In 1985, the 239 Yen bought $US1 and by 1988 the Yen had appreciated to 128. By 1985 it was around 80. It is clear that the bi-lateral trade balance didn’t react very much at all.

There are debates about why that result occurred including complaints by the US that Japan imposed import restrictions. The most patent reason was that the rapid appreciation of the Yen created fears of a major recession in Japan and they reacted to the loss of export competitiveness by loosening monetary policy and the lower borrowing rates.

This subsequently was a factor in the huge real estate boom in the late 1980s that led to its property price meltdown and subsequent “lost decade”. During this meltdown Japanese imports collapsed as national income declined sharply. Further, the carry trade since then has kept the value of the Yen lower than otherwise (given the low interest rates) thwarting to some extent the policy of the US to keep it “overvalued”.

China and domestic growth

What might have explained the lack of responsiveness between 2005 and 2008 of the bi-lateral trade balance as the yuan appreciated? After all the outcome noted above was contrary to the mainstream textbook model predictions. There are several reasons why the textbook treatment of this issue failed to provide an adequate prediction.

First, it is not commonly understood but China is not a large manufacturing nation. It is an assembly line for components manufactured elsewhere. So a good proportion of the Chinese export to the US are not made in China and so the yuan-sensitive input proportions of Chinese goods are sometimes quite small. That means an appreciating yuan will only alter the export price by a small margin.

Second, China imports similar goods from the US, Germany and Japan – IT items, sophisticated capital goods (for example, jet engines) and so stimulating US exports to China is not a simple matter of appreciating the yuan against the US dollar. The US dollar parity against the Yen and the Euro is more important.

Third, for many low-cost, labour intensive exports, an appreciating yuan will just redistribute the exports among other Asian nations. Countries like Malaysia, Vietnam and Bangladesh are in direct competition with China to access US markets and a relative price change in the yuan against the US dollar would see China lose some of their market share but would not likely reduce the US trade position overall. Further, this would cause job losses and falling incomes in China and reduce their demand for US exports.

A much more sensible strategy – should you want China to grow their domestic market (and be able to support higher imports) – is to put pressure on Chinese firms, particularly those engaging with US companies – to increase the wages they pay their local workers. China is a poor nation overall with a less than comprehensive social security system. By encouraging high wages and more generous pension systems, the West would not only help China escape poverty but also reduce the “cultural” reliance on high private savings. In turn, the local population would have a greater capacity to purchase US made goods and services.

I will discuss this topic in more detail in another blog – I am running out of time this morning.

However, the idea that the world’s growth prospects rely on a rebalancing of world trade is erroneous and consistent with the claim that expansionary fiscal policy is not desirable.

There are several points we can make about this.

From a MMT perspective currency sovereignty requires flexible exchange rates. So the conduct of the Chinese government in terms of its exchange rate is not desirable under normal conditions. It is not only monetary policy that is tied under any sort of peg arrangement. Fiscal policy is also constrained. A country that operates on a gold standard, or a currency board, or a fixed exchange rate is constrained in its ability to use the monetary system in the public interest, because it must accumulate reserves of the asset(s) to which it has pegged its exchange rate.

This leads to significant constraints on both monetary and fiscal policy because they must be geared to ensure a trade surplus that will allow accumulation of the reserve asset. This is because such reserves are required to maintain the exchange rate parity. If a country is running a fixed exchange rate and faces a current account deficit, the domestic economy has to bear the brunt of the required adjustment.

So the government has to depress domestic demand, wages and prices in an effort to reduce imports and increase exports. Accordingly, the nation loses policy independence to pursue a domestic agenda. Floating the exchange rate effectively frees policy to pursue other, domestic, goals like maintenance of full employment.

Please read my blog – Modern monetary theory in an open economy – for more discussion on this point.

The caveat is that these constraints are not binding where a nation experiences a strong trade position such as China at present. In those case, there is fiscal space courtesy of the Balance of Payments capital account (financial flows boosting foreign reserve buffers). The general problem of external surplus countries is also avoided in these cases – that being that export-oriented growth resulting in persistent external surpluses reduces the domestic standard of living – because China has the capacity to offset this impact via fiscal policy.

In the current downturn, it has led the World in its use of domestic policy initiatives to ensure that unemployment impacts were muted and growth continued. China has clearly been ahead of the pack here and demonstrated how an appropriately applied fiscal stimulus can maintain domestic growth even as net exports are falling. Their example contradicts the claims by the deficit terrorists that fiscal policy is ineffective.

Further, MMT places a primacy on fiscal policy and thus considers monetary policy to be the weaker of the two in terms of its capacity to pursue effective counter-cylical stabilisation (that is, boost aggregate demand when private spending falls and vice versa). As I have noted often, there are many uncertainties about the use of monetary policy. It is a blunt instrument (that is, impacts across all regions if at all) and thus cannot be targetted. It’s final impact is also depenendent on distributional nets which are not clear – creditors and fixed income receivers gain, debtors lose – what is the net effect on spending?

For these reasons, fiscal policy is preferred and so the conventional arguments about the flexibility of monetary policy being constrained by a pegged currency are less important to MMT. But as noted above, all aggregage policy (fiscal and monetary) is constrained under a peg in unproductive ways.

MMT also takes a different view on trade to that outlined in mainstream economics textbooks. Imports are benefits to a nation while exports are a cost. The mainstream position is that imports are somehow bad too many of them is worse and exports are virtuous. Exports involve a nation giving up its resources to another nation so the citizens in the latter can enjoy them. That is a cost. Imports are the opposite.

The US trade position (deficit) is actually a boost to their standard of living. If the US government was successful in forcing the yuan to appreciate and, in turn, choke of imports then this would in the short-term further reduce the material standard of living of Americans who are already suffering under with the unemployment and income loss fallout of their collapsed economy. By denying the US citizens access to the cheapest possible imports the US government would be compounding the consequences of their failure to implement fiscal policy of sufficient magnitude and jobs focus as private demand collapsed. The so-called “huge trade deficits” are benefits to the United States and Europe.

But the US government would also be promoting a lower US dollar parity overall which would just entrench these “costs” (lower real terms of trade) over time.

Further, as long as the developing countries haven’t signed up to IMF-bullied currency-pegs or other limitations on their currency sovereignty, they have the domestic capacity to improve standards of living without a reliance on net exports (with exceptions when food is totally imported).

China clearly understands that it has the fiscal capacity to stimulate domestic demand. Most of the growth in recent years has come from public infrastructure spending. Please read my blog – China is not the problem – for more discussion on this point.

I would also note that no-one is forcing the US citizens to buy Chinese-made goods and services. The logic of the “land of the free” is to let people buy what they like.

So in that context, it is unclear why US commentators and politicians would want to push China in this way. China’s exchange rate policy is holding the US dollar up against the renminbi. But the nation with the stronger currency has the upper hand which is contrary to the way the mainstream economists and public commentators think.

A strengthening currency tells you that the real terms of trade are improving. That is, more real goods and services can now coming into shore on boats than have to leave shore. That is a net benefit. You can buy more real goods and services from abroad for less sacrifice in costly exports.

The appropriate policy reaction to the “demand draining impacts” of this outcome is to use fiscal policy to maintain strong aggregate demand and employment. In that way, the nation can maximise its “enjoyment” of its superior currency position – it generates enough income (and saving) in the private domestic sector to purchase goods and services on offer as well as being able to buy on superior terms the goods and services that arrive on boats from abroad.

I will write more about this in the weeks to come.


The simple line being pushed by the IMF, the World Bank, the US government and others about China is really a smokescreen to avoid facing up to the fact they have failed to implement appropriate fiscal policy. They should have expanded their deficits by much greater amounts in the early days of the crisis. They still short be increasing net public spending and creating local jobs. If the Chinese want to make or assemble cheap plastic items then the US workers can do other things.

But to say that the US government no longer has the capacity to increase employment in the US labour market unless China appreciates it currency is plainly false and amounts to the abandonment of the US government’s responsibility to manage the US economy in the interests of its citizens.

The appropriate policy response is not to start trying to modify trade or worry about what China is doing. The US government and other sovereign governments have all the capacity they need at present to stimulate domestic demand and create high levels of employment.

Ultimately China will realise that its citizens want more than bits of paper in foreign currencies and they will allow the exchange rate to float. There is already simmering pressure in China among workers to push for higher wages and a greater access to consumer goods. This pressure will not be able to be resisted by the Chinese government as time passes.

But I don’t want to be misinterpreted. I also think the yuan should float but for different reasons than those given by the pundits in the current assault on China. The point is that I think it is a side-show for the rest of us.

What we need to do on a multi-lateral basis is to curb the financial sector and force it to correspond only with the needs of the real sector. This would require large policy shifts which would outlaw most of the current trading behaviour and would require speculative behaviour to be advancing the stability of the real economy.

Saturday Quiz

The Saturday Quiz with the premium additions will be back tomorrow some time with Answers and Discussion on Sunday.

On Sunday I am catching the Eurostar to London where I will be staying all of next week. I have some meetings and other things to do.

That is enough for today!

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    This Post Has 125 Comments
    1. Two idiots commenting on things they know nothing about in one weekend (well maybe one who should know better).
      Wayne Swan moaning that other nations are intervening to keep their currencies articifially weak to support exports and that great Qld donkey Bob Katter saying that the fair valur for the AUD is usd0.60 (“somewhere like after the Keating comments”).

      With the AUD up here what a perfect time for the Govt and private industry to be importing capital goods to help expand capacity for future production.
      If these dopes listened to their industry advisors just occasionally they might realise that commodity prices inversely track the USD and that terms of trade are extremely favourable at present before declaring Australian export industries about to implode.

    2. Dear Stone,

      If I could (extrapolating from SETI) “explore, understand and explain the origin, nature and instance of jrbarch in the universe” then that alone would be challenge enough for me! My chances are infinitely conditional and serenditious so I do concur: simple wisdom says stick to enjoying each day. And yes – focus on something you do like!! Yesterday is gone forever. Tomorrow never arrives! We are stuck in today, each moment – until one day, for us, it does not arrive. Until then, any sunset/sunrise will tell you: Life was meant to be celebrated and enjoyed! If I were in SETI I would do that first, then look for Life’s origins on Friday afternoons (after reading billy blog of course)! Cheers …


    3. @Stone
      I posted this “light” comment because I found the rogue economists post genuinely funny but also because the tactics for developed countries with surplus trade look obviously absurd and insane but are with us in reality.

      Now Germany has introduced shorter hours and the government subsidizes this scheme. But this is only an emergency policy. It will run out. For a more general sane economic policy I think we’ve to destroy the public bias/myth to be export-world-champion today, tomorrow and forever is a beneficial thing in itself.

      I don’t want to wade in the very sophisticated and technical discussions going on here. But I would like to note that there’s something like an FX market which is with us for quite a time. Now everybody who knows one or two FX traders als knows that these guys are very often spectacularly wrong in currency valuation. The FX market is notorious for being not aligned to what goes on the real world. Maybe I’ve missed it but I haven’t read in ante TGR years many pundits worrying about the FX market and wishing to reign in this inefficient global casino because its harmful for global trade balances.

      The only proposal in regard to the Chinese currency I’ve read so far which merits a discussion was on The Chinese government may impose a pollution/carbon/green tax on exports. Such a tax can surely compensate Chinese citizens for some nasty externalities imposed on them by foreign importers. It would also be seen as a bold move by the Chinese government to recognize the problem of pollution and climate change. It will certainly comfort the wish of the US public to see Chinese export prices rise relative to the US dollar. And who knows: maybe leading US climate change deniers will have a harder time. My prediction: it will mostly shift demand to export nations with free for all pollution/exploitation policies.

    4. @Stone
      I posted this “light” comment because I found the rogue economists post genuinely funny but also because the tactics for developed countries with surplus trade look obviously absurd and insane but are with us in reality. (For whatever reason WordPress doesn’t like the rest of my comment ;-)

    5. @Stone
      Please ignore the last comment. I didn’t get that there are so many comments that WordPress put mine on a new second page. May fault.

    6. Gamma October 11, 2010 at 7:13,

      Gamma – again I don’t have the facts, but I expect that if they were available, you might find that the State treasury functions actually have lines of credit and credit limits with the commercial banks.

      This aspect of credit limits is the most interesting operational difference in my view between the sovereign “currency issuer” and the government levels below that. Clear limits on the one hand; somewhat open ended idea about lack of constraints at the other.

      I doubt very much that the actual banking relationships at the lower government levels are public. But somewhere there must be a general description of the nature of such arrangements. Couldn’t get anywhere on Google though.

    7. Ramanan – I’m sorry but I am finding you ever more opaque.

      “Most governments and their central banks restrict demand as a result of the external factors even though they are not resource constrained and other measures such as capacity utilization are not high to warrant such an action. ” – I’ve no idea what you mean. Can anyone else paraphrase to make clearer?

      You bring up Iceland, but as has been pointed out, the country was one tiny hedge fund, plus they must have had loads of non ISK debt – ie non sovereign.

      I agree with Min that the 1970s period appears of interest; unfortunately, your example of the UK is pretty useless as a necessary condition for the 1976 sterling crisis was the UK trying to maintain a dirty peg – ie, in MMT terms, the UK was abdicating its sovereignty. Does Thirlwell have any other examples? How does he flesh out his US BoP constraint argument?

      stone – I think I probably agree, but the level of wealth tax reqd would be a political non-starter (and critically – even more politically unpalatable than the level of full-employment deficit spending MMT prescribes…)


    8. MMT Proselyte, I’m interested to hear that a wealth tax sounds less palatable than the current smorgasboard of different taxes. A wealth tax instead of the current taxes would mean that most people would be paying massively less tax (as wealth is currently so unevenly distributed). The citizens dividend would mean that people currently “on the dole” could take any work without it cutting into their benefits. I’m left scratching my head as to why we continue to let a handful of oligarchs dictate terms to us.

    9. MMT Proselyte Even if they were in the richest 10% they would pay less tax. Its the 0.01% who have the distorting levels of wealth- and they are not even remotely likely to ever spend much of it.

    10. MMT Proselyte,

      Thirlwall’s law is valid for most nations except the US and Japan.

      I am going to end this here – if you see the posts in recent months, I have been insistent on many points. I have also been promising to not write on this anymore :)

      On the question of Iceland – of course, as is always the case, one can make all kinds of arguments. Here is a fact – a nation facing devaluation of its currency can only survive by making discretionary attempts to increase exports and come back to a trade surplus. The nation’s products may get the advantage of price competitiveness but non-price competitiveness is more important. Why would foreigners buy your product ?

      More importantly, I do not wish to be associated with analogies such as hyperinflation etc. What I am saying is that nations want to be a creditor to the rest of the world rather than a debtor. If imports are high, they will definitely face currency pressures and the only way to come out of it is to target a trade surplus. No one has seen the future and nations want as high a trade surplus as possible. Fact of life :-)

      The US has had major issues with trade imbalances – I find the solution of just relaxing fiscal policy alone without improving the trade performance silly. In fact, in the real world that is what is happening – Geithner has been trying continuously to do something and Obama has promised to increase exports. Nations want to be net exporters and that is the reason one talks of currency wars etc.

      Of course, they shouldn’t be worrying about fiscal deficits but fiscal policy alone will not solve US’s problems.

      Now most economists – mainstream or non-mainstream agree that imports reduce demand. In the US, the reduction of demand was not seen because of increase in demand created by private sector borrowing. When the private borrowing could not continue any longer, the effect of the trade deficit came back with a revenge. Now one can argue that the US could have relaxed the fiscal policy long back but that would have let the external deficits processes go on forever leading to both the public debt and the indebtedness to foreigners rising to unsustainable levels. The US should have targeted net exports long back by depreciating its currency and by support to the export industry.

      Coming back to my point you quoted. Here is from Marc Lavoie’s text Introduction To Post Keynesian Economics, Page 125

      Indeed, according to authors like McCombie and Thirlwall (1994), most governments impose severe constraints on growth as a response to external disequilibria arising from the overly rapid growth of imports. These countries have the means and the resources to grow rapidly, and they generate a domestic aggregate demand that is actually more than sufficient to justify a strong capital accumulation. Yet, these countries are constrained by a negative current account.

      It is true that a surplus in the capital account, arising from the influx of foreign capital, can easily compensate for the negative current account. But such a situation can only be a temporary one for countries other than the USA, since its currency serves as an international reserve asset. Indeed, countries cannot tolerate such current account deficits for too long because of the interest and dividends that must be paid on the accumulated external debt and foreign investments. In the long run, therefore, the current account must be balanced and imports must, at most, be equal to exports.

      The point is that when nations run into current account deficits, they tighten fiscal policy to reduce demand and since imports depend on demand, it is hoped that imports are reduced. Exports on the other hand depends on demand in the foreign countries and won’t be affected much. Now whether you like it or not is a different matter, but thats the game. They also target exports but the first step is curbing demand.

      Now my comments are to highlight the fact that doing the opposite is a highly unsophisticated solution. The only way is for everyone to come together and decide how to trade with one another. Fiscal policy will then be the winner.

    11. JKH,

      All Australian state govts issue bonds and notes directly into the primary market. Some of them may also have credit lines at commercial banks (the smaller states perhaps) but I think this would be secondary to bond funding.

      The biggest two issuers are Queensland with AUD 61.5bn outstanding and New South Wales with AUD 43.5bn outstanding. For comparison the Federal govt only has about 165bn on issue.

      For these 2 state issuers, something like 30% to 40% (my quick estimate) is in lines which are guaranteed by the federal govt.

      I have put the question to Bill, but he has either missed it or chosen not to answer, perhaps you could hazard a try:

      What is the fundamental difference between debt issued by the state govts to debt issued by the federal govt? Why does MMT theory claim that a govt bond adds to NFA while a semi-govt bond does not given that:

      1) Semi-govt bonds are repo-eligible. They can be presented to the reserve bank in exchange for settlement funds exactly like govt bonds.
      2) Some semi-govt issuance is guaranteed by the fed govt anyway
      3) In the monetary system AS IT CURRENTLY STANDS neither the federal govt or the state govts are “sovereign currency issuers”. The currency issuer in Australia is the Reserve Bank of Australia, which is independent of government. All govts federal and state must borrow to cover deficit expenditure – this is a fact, like it or not.

      My view is this. There is not a hard and fast distinction between “sovereign” debt and “non-sovereign” in this case. It is more a matter of degree, than of fundamental difference. So therefore the theory that we can analyse the economy by looking at the level of NFAs (as defined by MMT) is flawed. The idea of “Net Financial Assets” as being something particularly useful to look at is a red herring.

      It tells us very little, and in fact actually masks certain things which are of importance, such as semi-govt borrowing and spending which it dismisses as less important because “it all nets to zero” (whatever this actually means) within the “non-govt sector”.

    12. The only voluntary sustainable control over population growth is education.

      Actually, economic development reduces population growth.

    13. Now everybody who knows one or two FX traders als knows that these guys are very often spectacularly wrong in currency valuation.

      I know fx traders that have done spectacularly well for a time, only to be spectacularly wiped out later. Their excuse is the same: Governments rigged the market. Of course, that is impossible to prove.

    14. Gamma,

      I believe the MMT theory would be that the federal government can change the institutional mechanism for borrowing and eliminate it, effectively backing into the central bank for all “funding” (i.e. simply by “crediting bank accounts” and creating banks reserves in the process).

      The state governments don’t have the same flexibility, assuming they would be under commercial bank credit limit restrictions if they chose not to issue or could not issue bonds.

      Those same credit limits would apply if the commercial banks bought state bonds and repo’d them at the central bank. It isn’t the central bank facility that restricts credit availability in that case – its commercial bank credit risk to the state borrowers. And the state governments can’t come directly into the central bank for funds.

      But I agree that it’s a question of degree. If you group the federal government together with the states, it would seem both have the capacity to generate NFA based on that group definition.

      I think the distinction in degree boils down to my point on credit limits. The federal government is far less restricted and has more fire power because of both its size and its “currency issuance” potential. It effectively “owns” the bank – given its option to change the institutional requirement to borrow.

    15. Dear Gamma (at 2010/10/12 at 2:59)

      First, the Australian government has chosen to impose the voluntary arrangements with respect to the conduct of fiscal policy. It can change them any time it chooses. The state governments can never change them and will always have to fund themselves in a way similar to a household.

      Second, you will say that the central bank (RBA) is independent whereas I will point out the facts that this is also by convention. The Australian government chooses the Board of the RBA, it can overrule any RBA decision and given the RBA is a legislative contrivance of the Federal government it could vote to collapse all RBA functions into the Treasury whenever it wanted to. The government could also order the RBA to credit any bank accounts it desired any time it wanted that to happen with no debt issuance at all. The state governments could never achieve that.

      Third, the Australian government can disband the Australian Office of Financial Management whenever it chose just like it set it up by choice. The state governments could never do that.

      The fact that the federal government behaves as if it is facing a financial constraint is purely political and can be altered any time it wanted. The state governments, by definition, will always be financially constrained. MMT demonstrates that fundamental difference and the implications of it. MMT shows that the financial constraints on the federal government are political and voluntary. The mainstream textbooks etc try to make out that the constraints are intrinsic and therefore misrepresent the facts.

      I did not ignore your point – I just thought the flaws in it were so obvious that I didn’t think I should respond.
      best wishes

    16. JKH,

      So MMT theory asserts that a hypothetical possibility (the fed govt changing the present currency arrangements) mean that the two assets that share very similar characteristics (and investors) are actually fundamentally different.

      I don’t think it’s reasonable to seperate the federal and state govts and suggest that they are fundamentally different animals. In exactly the same way that the central bank would come to the aid of the federal govt (or the current arrangements would be abandoned/revised as you speculate) the CB or federal govt would come to the aid of the states if they were similarly threatened.

      There is a very good reason they are called semi-govt issuers – there possess an implicit “sovereign” guarantee, which is perfectly well-founded. In fact, some of their bonds (as I mentioned above) actually have an explicit guarantee.

      I guess I would agree with you that state govts do effectively face a tighter credit limit (to use that term) than the federal govt, but in my experience it is effectively a very small difference.

      Perhaps the Australian situation is unusual. During the 90s and 00s when the federal govt was running budget surpluses and retiring debt, the states were running deficits and issuing debt. So state debt began to replace or augment govt debt in many ways. In fact the fed govt wanted to retire ALL govt debt, and it was only because they were convinced by the financial markets that we needed enough bonds to support a liquid futures market that they did not.

      Therefore I would suggest that for the idea of using NFAs as any sort of useful metric, you would have to classify much/most of the semi-government debt as NFAs (at the very least, the explicitly guaranteed lines).

      Then you would have to start questioning whether you should include other assets in the economy which are also explicitly guaranteed by the federal govt. In Australia there is a lot of bank-created assets which are guaranteed – bonds and deposits. Therefore you probably need to include these as NFAs. If not, why not?

      At this point the previously neat and appealing concept of a binary distinction between “assets which net to zero” and “NFAs” is starting to crumble and become less and less useful considering all the exceptions we are making.

      At this point, you might come to the conclusion as I have, that it is actually a graduation rather than clear distinction.

      Therefore it is more useful to consider assets on the basis of how much default risk they carry on a sliding scale between the two extremes, not whether they are “net positive” or “net to zero” which I think is actually quite an ill-defined distinction to make.

    17. Bill,

      “The state governments, by definition, will always be financially constrained. MMT demonstrates that fundamental difference and the implications of it.”

      2 quick questions:

      1) Do you consider semi-govt bonds which have an explicit federal govt guarantee to be NFAs? The existence of these lines suggest that that the “financial constraints” facing the states are perhaps not as strong neatly-defined as you make out.

      2) Do you think there is any significance in the fact that all semi-govt bonds are repo-eligible at the RBA?

    18. Ramanan, you several times made this claim: \”What I am saying is that nations want to be a creditor to the rest of the world rather than a debtor.\”

      I am sorry but you are making an false aggregation here. I, as an arbitrary citizen of arbitrary country living in another arbitrary country, want to have higher income and lower prices. That is all I want in material sense and will ever want. Your claim above is completely false. If you ask a nation about what it wants I am sure-sure you will get the answer I gave above.

      What comprises cheap prices is pretty clear and if imports can provide cheaper prices so let it be imports. However what comprises higher income is an open question where some issues with aggregation and distribution might arise. You claim that intentional lowering of living standards by shipping goods produced locally abroad in exchange for financial income is a more prudent way to get financial income when compared to government\’s fiat capacity. You next claim that it is true because there might be a point in time in the future when the latter option can threaten something without specifying what. So playing along your argument and assuming that it is really not \”if\” but \”when\” then in order to get any credibility you have really specify what it is that will happen whenever it happens. You might have a proper worry and I believe many people here would by empathic to your worry but a worry does not make an argument. Pretty much like the fact that some people are worried to fly does not make an argument that flying is dangerous. On the contrary flying is one of the safest means of transportation.

      And please also note that once you outline what might happen there is nothing that can stop you from getting ready for such scenario.

    19. Sergei: the average Joe in the nations receiving USD in exchange for real goods might not be quite so delighted with the terms of trade as the elites who call the shots and all ready have so much that money means more than real goods to them. That average Joe might fly a plane into a sky scraper- just a hypothetical example of the kind of things that might happen if there is a blatently inequitable system.

    20. Sergei,

      “I am sorry but you are making an false aggregation here. I, as an arbitrary citizen of arbitrary country living in another arbitrary country, want to have higher income and lower prices. That is all I want in material sense and will ever want. Your claim above is completely false. If you ask a nation about what it wants I am sure-sure you will get the answer I gave above.”

      I thought Obama wants an export-led growth. Other nations too are in the “currency wars” – because they want to be net exporters.

      Your claim is true but doesn’t contradict my claim.

    21. Ramanan, Obama etc. want to be exporters because they still live in the gold-standard mentality where exports were a critical ingredient required to grow money supply and economy. The world has changed. So do no stick to history. Every nation with floating currency can grow its economy without any need to export.

      Some people are scared to fly but it is an extremely safe and fast way to get to the destination.

    22. “What we need to do on a multi-lateral basis is to curb the financial sector and force it to correspond only with the needs of the real sector. This would require large policy shifts which would outlaw most of the current trading behaviour and would require speculative behaviour to be advancing the stability of the real economy.”

      I do like the way you tack this on the end like an after thought. Since we have a credit system with a stunted fiat system attached like a withered appendix, surely MMT is subordinate to the financial system. All MM theorising is moot, without addressing exponential credit creation first.

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