I have received many E-mails and direct twitter messages overnight and today following the ‘debate’ on Real Progressives yesterday, where trade issues and related financial transactions were discussed. I saw that section of the debate (after the fact) and concluded that only one of the guests knew what happened when nations exported and imported. But it appears that readers of this blog who listened to the debate were confused by what they heard. So, today, by request, I aim to clarify a few of these issues. They are in fact fairly simple to understand once you trace through the transactions carefully, so it is a surprise that basic errors were expressed in the ‘debate’. So here is the way Modern Monetary Theory (MMT) helps you understand trade transactions.
There appears to be a lot of confusion about the external economy in a fiat monetary system. Many economists do not fully understand how to interpret the balance of payments in a fiat monetary system.
So it is no surprise that the general public struggles in this domain.
For example, most economists will associate the rise in the current account deficit (exports less than imports plus net invisibles) as an excess of investment over saving.
The claim is then that the only way a nation can counter that imbalance is through foreign investment (via an offsetting the capital account surplus) which means that the net accumulation of foreign claims on the nation (via direct investment income, debt repayments or equity dividends) increases.
This is the so-called ‘living beyond our means’ narrative.
I considered these questions in detail in this blog post – Modern monetary theory in an open economy (October 13, 2009).
In the ‘debate’ yesterday, we heard that nations with current account surpluses are more robust and that current account deficits reduce potential growth because the increasing foreign ownership reduces profit retention and hence investment.
The claim is unsustainable in fact.
First, there was a denial that exports are a cost and imports are a benefit. That should be undeniable.
For an economy as a whole, imports represent a real benefit while exports are a real cost.
Exports mean that we have to give something real to foreigners that we could use ourselves – that is obviously an opportunity cost.
Imports represent foreigners giving us something real that they could use themselves but which we benefit from having. The opportunity cost is all theirs!
Thus, net imports means that a nation gets to enjoy a higher material 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).
German workers, for example, give up hours of labour time, and utilise all sorts of raw materials to make motor cars and motor cycles, which they then put on ships and send elsewhere for the enjoyment of others. That is a real cost to Germany because it could use those productive resources for themselves.
So, on balance, if we can persuade foreigners to send us more ships and airplanes filled with things for us, than we have to send them in return (net export deficit) then that has to be a net benefit to us in real terms.
How can we have a situation where foreigners are giving up more real things than they get from us (in a macroeconommic sense)?
The answer lies in the fact that our current account deficit ‘“finances’ their desire to accumulate net financial claims denominated in $AUDs.
Think about that carefully. The standard conception is exactly the opposite – that the foreigners finance our profligate spending patterns.
In fact, our trade deficit allows them to accumulate these financial assets (claims on us).
We gain in real terms – more packed ships full coming in than leave – and they accumulate $AUDs, in the first instance.
What happens to those $AUD stocks is another question (see below).
If the foreigners change their desires to hold financial or other assets denominated in $AUD then the trade flows will reflect that and our terms of trade (real) will change accordingly (because they will make it harder for us to get foreign exchange to buy the imports).
It is possible that foreigners will desire to accumulate no financial assets in $AUD which would mean we would have to export as much as we import.
In that case, a nation would have to adjust its export and import behaviour accordingly. If this transition is sudden then some disruptions can occur. In general, these adjustments are not sudden.
Now what are the ‘monetary’ effects of this.
A simple understanding that net financial assets can only be created and destroyed in the non-government sector through transactions with either the central bank or the treasury (the ‘consolidated’ government sector).
Government deficits are the sole source of net financial assets for the non-government sector. All transactions between agents in the non-government sector net to zero.
This accounting reality means that if the non-government sector wants to net save (spend less than it earns) in the currency of issue then the government has to be in deficit.
The sectoral balances derived from the national accounts generalise this result and show that the government deficit (surplus) always equals the non-government surplus (deficit).
Fiscal surpluses destroy non-government wealth by forcing the latter to liquidate its wealth to get cash and destroy liquidity (debiting reserve accounts), which is deflationary.
With an external deficit, fiscal surpluses result in increasing private domestic sector debt levels and cannot represent a sustainable long-term growth strategy.
The following graphics will help trace out the transactions that accompany trade.
- I wish to buy a car, which is manufactured in Japan by a company that has costs in Yen and measures its profit and loss in Yen.
- The factor ships cars to Australia to its dealer network and bills the network in Yen.
- The car dealership accepts the yen-liability but sells the Japanese-made car in $AUD.
- If I pay cash or wave a credit card across a sensor at the car dealership (digital cash), my bank reduces my deposit balance by $A20,000 (the price of the car) and the car dealer’s bank would increases the dealers deposits by the same amount.
- The central bank (RBA) records a decrease in reserves for my bank and a corresponding increase in reserves for the car dealer’s bank as part of the clearing process.
- The debit to my bank account is debited and the credit to the car dealer’s account means that the ownership of the $AUD has changed from me to the dealer. No new net financial assets are created.
- If I take out a loan to buy the car, then my bank’s balance sheet now records the loan as an asset and creates a deposit (the loan) on the liability side. When I hand over the cheque to the car dealer (drawing on the loan), the dealer now has a new asset (bank deposit) via the fact that loans create deposits within the system. Again, no new net financial assets are created.
What happens next depends on the aspirations of the car manufacturer.
1. They might want the invoice paid in Yen.
2. They might be happy (if the dealers are wholly owned by the manufacturer) to leave the sales revenue in $AUD accounts at Australian banks.
3. They may decide to purchase AUD-denominated assets (financial or otherwise).
Whatever choice they make, at this stage, the export surplus (1 car) manifests in an accumulation of $AUD assets in the form of a bank deposit (or equivalent).
What happens if the car dealer decides to pay the invoice from the manufacturer? Clearly, there is a currency mismatch. The dealer has $AUD financial assets whereas the invoice requires Yen to be transferred.
- The car dealer has $AUD and needs to get ¥. After deducting their profit, the car dealer will then enter the foreign exchange market (maybe via their bank) and negotiate an $AUD for Yen sale. So someone is currently holding Yen and desires to hold $AUD for whatever purpose.
- A contract is initiated and the two currencies are exchanged.
- The car dealer then transfers the Yen purchased from the counterparty to the Japanese bank of the car manufacturer (we ignore hedging etc, which would have been in operation to cover the uncertainty of the mismatch between revenues and costs).
- The resulting financial effects are: (a) The AUD balances in the Australian financial sector remain the same but are owned differently than before the export occurred. (b) the Yen balances in the Japanese financial sector remain the same but ownership has transferred from the Foreign Exchange dealer to the car dealer and finally to the car manufacturer.
If the manufacturer decided to accept payment of the invoice in $AUD (then the foreign exchange market transaction would be unnecessary) and the transaction would just mean that the Japanese car company would have a new $AUD financial asset (bank deposit).
What it did with that deposit doesn’t alter the fact that all the export has achieved (other than allow me to have a new car) is transfer the ownership of my $A20k deposit to the car firm (including the dealership).
It is more complicated if the $AUDs are converted into Yen, but not overly so, as explained above.
The transaction (and by accounting definitions) net export surpluses do not increase the yen or $AUD balances, just change the ownership.
Now, what would happen if the Japanese car firm decided to store its $AUD assets in the form of Australian Government debt instead of holding the AUD-denominated bank deposits?
Some more accounting transactions would occur:
- The Japanese company would instruct its agent to put in an order for the bonds and the firm would instruct its Australian bank (wherever it was located in the world) to transfer the $AUD bank deposit into the hands of the central bank (RBA) who is selling the bond (ignore the specifics of which particular account in the Government is relevant). The Japanese car maker’s lawyers or representative, in turn, would receive a bit of paper called an Australian government bond.
- The Australian government’s foreign debt rises by that amount.
- This merely means that the Australian Government promises, on maturity of the bond, to credit the bank account of the ultimate holder of the bond (add reserves to the Australian bank the car firm or final holder deals with) with the face value of the bond plus interest and debit some account at the central bank (or whatever specific accounting structure is involved with bond sales and purchases).
If you understand all of that then you will clearly understand that this merely amounts to substituting a non-interest bearing reserve balance for an interest-bearing Government bond. That transaction can never present any problems of solvency for a sovereign government.
Project Fear continues …
Then we hit the Project Fear claim that that foreign purchases of a government’s treasury debt props up that nation’s public spending and, without it, the government would have no financial viability.
The corollary of this theme, is that the power lies in the hands of those foreigners who hold the national government debt rather than the issuer, the national government.
China automatically accumulates US-dollar denominated claims as a result of it running a current account surplus against the US.
These claims are initially held somewhere within the US banking system and can manifest as US-dollar deposits or interest-bearing bonds. The difference is really immaterial to US government spending and in an accounting sense just involves adjustments within the banking system.
The accumulation of these US-dollar denominated assets (bits of paper and electronic bank balances) is the ‘reward’ that the Chinese (or other foreigners) get for shipping real goods and services to the US (principally) in exchange for less real goods and services being shipped from the US.
Given real living standards are based on access to real goods and services, you can work out, from a macroeconomic perspective, who is on top.
Please read my blog – Modern monetary theory in an open economy – for more discussion on this point.
Note, I used the qualifier ‘from a macroeconomic perspective’. A US worker in Detroit who has endured unemployment as a result of cheaper imports coming from nations with lower labour standards (pay and conditions) than the US is unlikely to be among those who benefit.
The US thus benefits from China’s willingness to deprive its citizens of material wealth (use of its own real resources) and net ship its ‘labour’ and other real resources embodied in the exports to other nations.
This is not to deny that when an economy experiences a depletion of foreign exchange reserves or finds the exchange terms of its own currency against foreign currencies it requires to purchase essential imports it has to take some hard decisions in relation to its external sector.
This is especially so if it is reliant on imported fuel and food products. In these situations, a burgeoning external deficit will threaten the dwindling international currency reserves.
In some cases, given the particular composition of exports and imports, currency depreciation is unlikely to resolve the CAD without additional measures.
The depreciation, in turn, raises the relative costs of imports, and imparts an inflationary bias to the economy. Moreover, depreciation leads to expectations of further depreciation and fuels the run out of the currency. There may be no interest rate that is high enough to counter expectations of losses due to depreciation and possible default.
The reality is that a nation facing a lack of ability to purchase imports, for whatever reason, has to either increase its exports or reduce its imports.
For less developed countries faced with currency crises, there is probably no short-run alternative but to urgently restore reserves of foreign currency either through renegotiation of foreign debt obligations, international donor assistance or default.
For an advanced nation, similar constraints might apply and a sudden shift in international sentiment against the nation or other financial assets denominated in that currency are no longer deemed as desirable, then adjustments in the flow of real goods and services sourced from foreigners are required.
And, as I explain in this blog – Ultimately, real resource availability constrains prosperity – the limits for a nation are clear – if it cannot command access to real resources owned by foreigners the it must rely on the resource wealth it has for sale in its own currency.
But none of that reduces the financial capacity of the currency-issuing government to purchase whatever is for sale in that currency.
What would happen if the Chinese holders of US government debt decided to liquidate their holdings of US government debt that have been accumulated to mirror the current account deficit the US runs against China?
This could be done slowly or quickly. A rapid liquidation would devastate the Chinese wealth stored in those $USD assets.
Such a liquidation would have no bearing on the US government’s capacity to buy goods and services for sale in US dollars but would seriously undermine the trading capacity of China.
Please read my blog post – Do current account deficits matter? (June 22, 2010) – for more discussion on this point.
Nominal versus real
But what is the discussion about real and nominal about?
Think about this simple example.
When I go to a shop and buy a good from the store I hand over some cash (or wave a credit card over a sensor which is the digital equivalent of handing over cash) and receive the product in return.
The shop is receiving a nominal payment and sacrificing a real good. The shop wants to accumulate nominal stocks of money whereas I want the real good to consume its use value when I leave the shop.
I clearly value the real benefits from the transaction more than I value the nominal holding of cash.
All commodity transactions share that characteristic except the transaction that involves an employer purchasing labour power in the labour market.
That transaction, as Marx so clearly showed, is unique, because unlike simple commodity exchange – where the exchange value is set during the transaction and the use values arising from the exchange are consumed outside of the exchange – the labour exchange is different.
Unlike the symmetry of a simple commodity exchange, there is an asymmetry in the labour exchange.
For the worker, the use value of the exchange is embodied in the wage received and that is consumed outside the workplace (we abstract from a worker enjoying his/her job).
But for the employer, the purchaser of the labour power, the use value of that ‘commodity’ – the flow of labour – has to be consumed during the transaction period. That introduces all manner of issues include the need to control what the worker does, etc.
So a nation with a current account deficit enjoys a real advantage over the export surplus nations (as explained above) but incurs nominal liabilities – the financial assets that the exporter accumulates.
The exporter could convert those nominal liabilities into real assets (via say FDI – see below) or not.
As I explain below there are some reasons to be concerned about the accumulation of financial assets in the hands of foreigners but they are not the usual suspects (such as the case discussed above concerning liquidation).
There was also the contention that a nation that runs a continuous current account deficit ends up only being a nation of workers.
The assertion was that the capital account of the Balance of Payments would reflect the increasing foreign ownership of companies in a nation with a current account deficit and that if that persisted all the “capitalists” would be foreigners.
In turn, it was asserted that this would mean profits were expropriated abroad, which would lead to reduced business investment (capital formation), slower growth, and declining standards of living.
We can break the assertion up into its two components.
First, Australia is a small, open economy and has been running persistent current account deficits for as long as the most recent national accounting data has been available (September-quarter 1959).
It has been in continuous deficit since the September-quarter 1975 as the following graph shows (from March-quarter 1960 to the December-quarter 2017), averaging 4 per cent of GDP over that time.
Hardly a small deficit.
Second, one can find ownership of Australian companies from the Australian Bureau of Statistics publication – Selected Characteristics of Australian Business, 2015-16 (latest published).
The following table is compiled from that data and refutes entirely the notion that our persistent current account deficit has lead to a mass takeover of our business firms by foreign capitalists.
In 2016, only 2 per of business in Australia were foreign-owned
Unfortunately, there are still plenty of Australian capitalists doing their thing in Australia :-)
The ABS also published data on – International Investment Position, Australia: Supplementary Statistics (Catalogue 5352.0). The most recent data is for 2016.
The national accounting framework divides financial flows into and out of a nation into Foreign direct investment (FDI) where funds are used to establish an operational business interest of at least 10 per cent ownership (including equipment, buildings, land) in a foreign country and Foreign portfolio investment (FPI) where funds are used to buy financial assets (shares, bonds) in a foreign country.
FPI is divided into liabilities accruing from equity investment (shareholdings) and debt securities (loans).
The following graph shows the aggregates since 2001 for Australia. So much of the financial side of our current account deficit is in fact reflected by foreign debt positions held by the private domestic sector.
Remember the previous graph shows the stock of foreign investment in Australia. So in 2016, total FDI was $A796,072 million while total Australian FDI abroad was $A554,874 million.
For FPI, the 2016 total foreign liability was 1,659,820 million while the total foreign asset was $A869,818 million.
The Net international investment position in thus less for FDI than for FPI.
But from the Balance of Payments data we can also extract more information that bears on this discussion.
The above data is for stocks – so the total assets and liabilities measured at some discrete point in time (annual in this case).
But the stocks of assets (arising from FDI and FPI) generate income flows into and out of the country.
And the question of interest, given the assertion that profits disappear from nations running current account deficits, is what proportion of investment income arising from FDI is reinvested?
The answer can be found in the ABS publication – Balance of Payments and International Investment Position, Australia, Dec 2017 (Catalogue No. 5302.0).
From March-quarter 2008 to the December-quarter 2017, on average 53.6 per cent of investment income flowing to FDI has been reinvested into new FDI in Australia.
So we have seen that a persistent current account deficit does not:
1. Lead to a takeover of local businesses by foreigners.
2. Lead to all profits being repatriated and investment falling.
Investment does not depend on who owns firms anyway
Further, the claim that local investment would suffer and growth would be retarded if foreign ownership increased as a result of current account deficits allowing foreigners to accumulate equity in local firms and repatriated all the resulting profits, misunderstands the way in which loans create deposits.
There is typically no ‘shortage’ of funds available for credit-worthy borrowers (including firms seeking funds to invest in new productive capital) in a fiat monetary system.
We could have a situation where all firms were foreign owned and repatriated all profits and, yet, the local banking system would still stand ready to create loans (and hence deposits) to firms that were deemed to be financially viable who were seeking funds.
Why might we care about foreign ownership?
I will write a separate blog post on this topic in the future.
The main reasons to be concerned are not related to takeover or lack of investment potential.
The idea of foreign ownership has long been a concern for progressives because ownership of financial wealth bestows power and allows the owners to influence government policy to their advantage.
Further, the accumulation of local currency assets can manifest in asset price bubbles (real estate) that disadvantage local residents, especially lower income cohorts.
In this regard, governments have to have strict rules in place as to which assets a foreigner can accumulate in the currency of issue.
More later on that issue.
I hope that clarifies some of these issues.
That is enough for today!
(c) Copyright 2018 William Mitchell. All Rights Reserved.