Current accounts and currencies

Its Sunday morning in Kazakhstan and cold. My meetings in Almaty are over and I am heading home today via Dubai (backwards to go forwards). It has been a long week and it hasn’t been helped by the fact I have come down with a heavy cold. But overall a lot was accomplished, not the least being the startng dialogues with the Central Asian government officials. I have also been thinking about the book on economic development that we have started working on (with a colleague at the Asian Development Bank). In this context, today’s blog is about development, trade and modern monetary theory (MMT). Many readers have asked me to comment on recent articles in the Australian press about our current account situation. So-called experts (not) are claiming the budget balance has to be cut back quickly to avoid an external crisis. The reality is that they fail to understand what the current account balance is about.

In terms of the book project, I have been motivated by the following thoughts. In general, most of the poorer countries have resources especially eager young populations. But despite all the IMF programs and economic growth elsewhere in the World over the lat 50 years, these countries are getting more or less poorer.

If you then consider that the advanced nations, for example, do not think twice about reticulated water supply – the technology was developed years ago – yet poor nations do not even have clean water and children die as a consequence. Further, advanced countries know how to control communcable diseases (I got the H1N1 shot for free the other week courtesy of the national government), yet poor countries still suffer epidemics of diseases the advanced world eliminated years ago.

So it is clear that the techology that we consider supports development is known, tried, largely effective and readily available. So then how do low income countries get it? An advanced nation buys it – either via private or public provision (or some mixture in the case of the hideous trend to private-public partnerships). So what stops the developing countries from getting it?

Most have their own currencies, although the oppressive world institutions like the IMF do everything they can to get them to abandon their own currencies and dollarise or peg. That is part of the problem. So they could purchase the technology with their own currency if we would sell it to them. No such luck.

My basic proposition is that by failing to understand how modern monetary systems actually operate, and instead, seeking to impose gold standard (fixed exchange rate-dollarised) conditions on developing countries, the advanced countries (operating through institutions like the IMF) have denied the poor nations the opportunity to develop. Not only have they forced the developing world to adopt positions of fiscal austerity which has denied the local populations of access to work, education, and social development but they have also denied the poor nations access to the technology that we enjoy in the advanced world (and I use advanced guardedly).

The entire system of development aid is flawed as it is backed by neo-liberal macroeconomic ideology which is anti-government. The stark result shown in this graph (which I published a few weeks ago but it is worth repeating) which shows the evolution of national income per capita since 1980 in the advanced word, Latin America, and the poor nations. The period chosen coincides with the imposition of the structural adjustment programs by the IMF on the poorer nations. Quite clearly after nearly 30 years of this oppression something better than what is evident should have occurred. In addition, over the same period the natural resource bases (including environmental health) in the poorer neations has been trampled by the greed of the advanced nations.

The graph comes from the World Development Indicators, provided by the World Bank. It shows Gross National Income per capita, which, in material terms is an indicator of increasing welfare.


What MMT tells us is that there are many opportunities that the poorer nations can exploit that they are currently bullied into foregoing by the advanced world. Any developing country can use its own currency to mobilise its workforce. As long as there is a basic capacity to tax or fine in the nation (that is, some institutional structure) then the currency will carry weight. Someone asked me during a presentation yesterday about macroeconomic policy design in the CAREC countries “who would want the Tajik currency?” Well the Tajiks who have to pay taxes in it for a start. All of those could be employed and receiving Tajik wages without any need for expensive technology.

But then what about a nation that has to rely on imported food? This is a major problem and I differentiate situations where a nation really cannot grow or produce any food from those where this shortage is induced by policy failure. For example, in the latter case, one of the problems with export-led growth strategies that the IMF promotes is that they tend to undermine the sustainability of the national food production in many agricultural-based nations. The typical IMF tactic is to force the nation which has a perfectly efficient and functioning subsistence sector to “modernise” (meaning to have plasma television sets) and this requires they convert their agriculture from subsistence to cash-crop-for-export.

Not only does this require different production technologies (for which the IMF duly provides the loans subject to conditions that undermine social development) but it is an approach that, by definition, cannot work for all nations. First, the technological changes wreck the basis of the subsistence farming so that if the export markets fail the local population cannot easily revert to feeding themselves as before. Second, world markets tend to get flooded with cash crops which drives the prices down and many countries then struggle to pay back their debts. The always-helpful IMF then is standing ready to provide more loans to rescue the defaulting-loans and yet more onerous conditions are imposed on government programs.

This is the vicious circle of poverty that is entirely policy induced. The whole strategy brings into question what we mean by development. Is modernisation (plasma TVs) development when it compromises equity, food security and the natural environment? I doubt it. Which means that while the poor nations are less developed – the advanced nations are over-developed and need to trim their sales.

But a nation might have a food supply problem just because of location. Then they have to import food. For example, in Kazakhstan where I am working at the moment, they face really significant problems in winter getting fresh vegetables and fruits. Many of these nations also have very little that the World wants by way of their exports. The fact that such a country’s national government is sovereign in its own currency and can spent how ever much it likes in that currency will not solve the problem – there is not enough goods and services (in this case) food for the sovereign government to purchase.

In those situations, a country requires foreign goods and they need to export to get hold of foreign currency or receive development assistance from the rest of the World. In the latter case, I see a fundamental change is required in the role of the IMF (more or less back to what it was intended to do in the beginning). Where are country is facing continual current acccount and currency issues as a result of the need to import essential goods and services, the IMF might usefully act to maintain currency stability for that country.

So as well as the Tajiks desiring their own currency the IMF might also stockpile it in order to stabilise the exchange parity. If this policy was pursued then much of the fears that are raised about currency runs and whatever would be allayed.

It is often claimed that MMT does not consider exchange rate issues sufficiently. I do not actually know why people think that other than they are just rehearsing their fears that somehow violent exchange rate swings are a common occurrence. They are not. But the story goes that the amorphous financial markets are poised to pounce on any country that runs a budget deficit and will destroy their currency if they feel there is no intention to get back into surplus.

The other angle on this is that deficits apparently fuel import growth and plunge the currrent account into further deficit which then leads to depreciation (if floating) or a foreign reserve drain (if pegged). This, in turn, leads to expectations of further depreciations and the currency is sold short by hedge funds.

They never really say the same thing about a private investment boom which sucks in imported productive capital. Somehow adding productive capacity in the private sector is “more efficient or more productive” than, for example, a large-scale public education policy which increases the capacities of the population in both the workplace but also general life.

They also never really say anything about private imports of luxury cars (so-called positional goods) into developing countries.

Whatever, we think about these different types of spending, the fact is that any growth will increase imports unless there are controls (tariffs, quotas etc) in place. I don’t support the latter. The only restraint on trade I would advocate would be that nations should engage in fair trade and not deal with countries which have laws etc that are contrary to the spirit of our own. In that regard, you might question my attitude to trading with China where the approach to human rights is not remotely consistent with my views on these things. Although, Australia hasn’t shone out very well in this regard with respect to our treatment of our indigenous population, refugees and more. But that is another topic altogether.

So the question that is always raised is that the full employment strategy I advocate for all nations, advanced or poor, will be unsustainable in a poor nation (with less foreign reserves) because it will blow out the CAD. Well it is entirely consistent with MMT for an increased budget deficit to increase imports and depending on what is going on with exports, also perhaps, increase the CAD. If imports are a function of national income (which they are) then any growth will cause this. So what?

The argument has a lot of underlying assumptions that are never really disclosed because the proponents of the claims think it is just sufficient to scare us using the currency meltdown-crisis jibe. First, it always assumes that private spending is better than public spending.

I can think of examples where that statement is true and other examples where it is false. In the CAREC nations, there has been much talk about creating advanced production clusters as a feasible development strategy.

That is fine although the paradigms that are often considered (for example, Porter’s triangle) are deeply flawed. But it is like wanting to run before you can walk. There is a huge need for mass education and skills development in these countries which the advanced nations accomplished via large-scale mobilisation of public resources. Why shouldn’t the poor nations exploit the approach that proved more or less successful in our case?

As a practical example, I was working for the ILO in South Africa last year evaluating the government public works (employment creation) program and helping to design a minimum wage framework to accompany the scheme, I was confronted with the view (by engineers) that it was acceptable to build roads there using state-of-art machinery that hardly required any worker being involved.

I argued that apartheid had left the country in a rather schizoid situation where they did have access to some of the best-practice machines etc and their engineers had been educated abroad and were equipped to use techniques that the US or Australia might use in 2009.

But a large part of the country still in a relatively undeveloped state courtesy of the oppressive white rule of the past. In those areas, it was better to use very labour intensive techniques to build the roads. A colleague of mine has shown these techniques produce the same high quality roads as the modern techniques can but employ thousands more workers per km of tar.

Second, there are hidden assumptions about entitlements? These take us into ethical areas. One way of looking at the CAD constraint issue is to consider the distributional assumptions. The IMF, for example, always advocate cutting back public spending to reduce employment and therefore the capacity to purchase imports. They also encourage lower tax levels allegedly to stimulate enterprise and incentives.

But another solution to the CAD issue (if it was really a problem) is to consider who is entitled to purchase imports. The IMF argument more or less says that unemployment and poverty has to be forced on selected cohorts in a nation to allow the high income members of the country to enjoy imported luxury cars, gadgets, and the rest of it.

Why not just tax or embargo those positional items and choke of their demand which would allow the domestic employment levels to be higher? That is what I would do. I find it unethical to force the unemployed to “finance” my imported lifestyle.

I will write more about MMT and trade balances but for now I want to focus on the issues raised last week in Australia about the sustainability of our CAD. This is in response to several readers overnight asking me to comment.

No worries, mate: living with a deficit, was Ross Gittins (Sydney Morning Herald) take on the ‘s economic commentator’s response to the Secretary to the Treasury’s (Ken Henry) claim that “the current account deficit is likely to get even bigger in the next few decades”. Gittins says that “… you don’t find many economists worrying about the current account deficit, either. Why not? Partly because Australia has run a current account deficit since the year dot … Because we’ve always been a ”capital-importing country”, needing the capital of foreigners to help us exploit our many investment opportunities.”

Which I agree with. But then he says:

When a country runs a current account deficit, this means its households, businesses and governments aren’t saving enough each year to finance all the physical investment the nation is doing in new housing, business structures and equipment, and public infrastructure. Its capital account surplus represents its call on the savings of foreigners to make up its ”saving-investment imbalance”. It follows that a nation runs a current account deficit either because it isn’t saving enough or because it’s investing too much.

This is not even remotely applicable to a fiat monetary system with flexible exchange rates. First, in such a monetary system, where the sovereign government issues the currency under monopoly conditions, there is no sense that can be made to the statement that the government saves when it runs a surplus. What a surplus accomplishes (apart from the accounting entries G < T) is the undermining of non-government saving. Surpluses squeeze non-government liquidity and force it to reduce their assets (or increase their debt holdings) to maintain growth in expenditure and service their tax liabilities to government. Gittins other point is that our CAD is largely driven by domestic investment running ahead of national saving which will generate returns that will enable "those businesses will service the interest on the money we've borrowed. But that's just as well because, as Henry says, all the big economic developments we face - a much bigger population, climate change, the information technology revolution and the resumption of the resources boom - will require huge additional investment spending, guaranteeing continuing, even bigger current account deficits." But this viewpoint is firmly contested by Labor-hack economist Ross Garnaut who is moving around the media at present promoting his new book (which was launched this week by his mate the Prime Minister). On October 12, 2009 Garnaut appeared on the ABC TV program 7.30 Report. When I read the transcript I thought how can someone who is introduced as “one of Australia’s pre-eminent economists” and who clearly has influence on national policy (at least when Labor is in power) have such a backwards understanding of how the monetary system works?

The following discussion should condition your assessment of his views on the current account deficit which we cover next. Further, we should not forget that his recent climate report (commissioned by the Labor Party when in opposition) has instigated the development of the totally flawed emissions trading scheme being pushed by the Government. The ETS will not reduce emissions significantly and is a totally wrong-headed way to go about addressing the issue.

Anyway, on the 7.30 Report, he was being interviewed about the book that the previous discussion about the CAD mentions. The basic hypothesis is that “… Australians face a painful readjustment after the crash – big cuts to Government programs and lower living standards than we are now used to”. He was asked by 7.30 presenter Kerry O’Brien to explain why there is “a lot of pain ahead for Australians, that we haven’t yet begun to contemplate. What sort of pain, and why?” His reply was along the lines that the private sector had over-extended and was spending beyond its means which was evidenced by the current account deficit.

Garnaut replied:

… I don’t think we can deliver current community expectations about continuations of increases in defence expenditure, health expenditure, big payments in free permits, to … for climate change compensation – all of that doesn’t add to to rather tight Budgets we’ll be running for a long time into the future.

While the likely payments for so-called “free permits” are just the product of Garnaut’s own flawed approach to climate change where the government basically hands out concessions to the worst polluters to placate them and keep things more or less the same. But even so, the national government will always be able to afford them.

The other items he mentions are all public outlays. Again, the national government has the spending capacity to provide these outlays. The debate should be focused on whether we want these things – why would we want to waste more money on defence for example? But the point is that if the political process determines that we want more killing toys then the national government can always meet those expectations in a fiscal sense, unless we run out of real resources.

Further, if there is a problem with excessive private indebtedness and over-spending, then the mirror image of that has been the excessive fiscal drag that the national government inflicted on Australia between 1996 and 2007. If you want the economy to grow and produce the saving capacity (via income growth) to allow the private sector to repair their precarious balance sheets then the last thing you would want to do is run “tight Budgets … for a long time into the future”.

What is needed when the economy has been driven by private spending funded by ever-increasing levels of debt (and a contracting public sector as a proportion of total output) then what is required is a change in the composition of final expenditure – from private to public – unless you want to “scorch the earth” and deliberately contract the economy.

The following graph shows public spending as a percentage of total spending in Australia between September 1959 and June 2009 (blue line). The grey columns are the nationaol unemployment rate for interest. The dramatic withdrawal of relative public spending as the national government ran increasing surpluses is clearly shown.

The only reason we would want to tighten the budget is if the private sector desired to spend more (without overwhelming itself in debt again) and/or net exports were surging (very unlikely). Given neither non-government demand boosts is likely and the fact that we have significant excess capacity (for example, 14 odd percent labour underutilisation), there is a need to restore the public contribution to total spending along the lines that were evident during the full employment period in the 1960s.


Now back to the week just gone. The Melbourne Age journalist, Tim Colebatch compares the views of Garnaut and Treasury Secretary Henry on the CAD in his October 24, 2009 article – Balance of power. He writes that:

Australia’s growth in recent years …[according to Garnaut] … has been unsustainable, because so much has been funded by increasing foreign debt — and you can’t increase foreign debt forever. “Australians,” …[according to Garnaut] … “were the spendthrifts of the commodities boom”. “If expenditure, both government and private, is allowed to expand too much when commodity prices are exceptionally high, there will be dreadful problems when it becomes necessary to adjust to lower living standards as prices fall to more normal levels.

So there are several claims here. An understanding of MMT clearly indicates that a growth strategy based on fiscal surpluses and dis-saving by the non-government sector is unsustainable. If we decompose the non-government sector in the private domestic and the foreign sector, then if the CAD is in deficit then the dis-saving is coming from the private domestic sector. Ever increasing indebtedness of that sector is unsustainable. But that is a different question to the growth in foreign debt.

An understanding of MMT would also suggest that a sovereign government should not borrow in a foreign currency which is different to selling bonds to a foreign buyer. I also would not allow banks to borrow in foreign currencies which is the major source of growth in foreign debt in Australia. But then I would curtail the operations of the local banks (whether they be locally or foreign owned) significantly as a major reform of the banking system. Please see this blog – for more information.

But that is also another matter to the CAD issue. An understanding of MMT reveals the true nature of the CAD. This came up yesterday in the “who would want our currency” discussions. The very fact that a current account is in deficit means that foreigners must be desiring to accumulate assets in the local currency. It cannot arise otherwise.

The point is that MMT constructs the CAD differently to the way in which the mainstream debate sees it. MMT starts with the obvious point (in real resource terms) that exports impose cost to the local population and imports provide benefits to the local population. So the motivation in exporting is to get the benefits. But you might also derive utility from accumulating foreign-currency denominated financial assets. In which case, you will be prepared under certain circumstances to endure net costs (on trade) to get access to the currency you desire.

In this construction, our CAD is “financing” the foreign desire to accumulate the AUD and presumably both parties benefit from the arrangement. That is a totally different conception to the more obvious “living beyond the means” interpretation that dominates the mainstream debate.

But having said that, an understanding of MMT also recognises that if foreigners stop wanting to accumulate financial claims denominated in our currency then there will be adjustments in our ability to net import and they could be painful.

Finally, if the foreigners stop accumulating our financial assets which will force a harsh correction on our ability to import at prices that are attractive that will have no implications for the capacity of the government to spend in its own currency. Garnaut is wrong to tie the movements in the terms of trade, the CAD and hence the exchange rate with the fiscal capacity of government. It is clear that terms of trade changes will alter private spending patterns and a depreciating currency driven by the commodity prices coming off their boom levels will divert private spending to the domestic economy.

This, of-course, provides opportunities for local firms to expand market share. But overall, these movements have no financial implications for government.

I also would note some inconsistency in the stance taken by pro-market commentators in the context of the CAD. If you believe in the market place (and Garnaut has much more belief in its efficacy than I have) then you have to support the sanctity of private contracting. Almost all of Australia’s foreign debt is privately-originated – mostly the banks. If the contract laws are transparent and people do not get bullied into unlawful or misleading contracts by the banks then you have to let the private sector borrow on whatever conditions they see fit.

Ultimately, if things turn harsh, there will be losses – but that is the nature of capitalism. The current crisis has brought some of these vulnerabilities into relief and we should understand that markets (including capital markets) fail badly and shift major costs onto “innocent” citizens.

An understanding of MMT suggests that it is the government’s responsibility to discipline the conduct of the banks to ensure that commercial interests do not subjugate public purpose given their centrality in the workings of our monetary system. But that is not the current system and so you have to take the good with the bad.

The Federal Treasury secretary does not agree with Garnaut either but for different reasons. Colebatch, reporting on a speech Henry made in Brisbane, says:

Henry argued that Australia faced “a set of structural changes more profound than anything in its history”: the ageing of its population, tackling global warming and adapting to it, the spread of the IT and communications revolution to the delivery of services …

Which means that we will have to keep importing to maintain high levels of productive investment. He also noted that China and India will keep the commodity prices at high levels because they are just at the start of their process of transformation into rich nations.

Does an appreciation require a cut in real wages?

A reader asked me to comment on a recent claim in the financial press that as Australia’s exchange rate is appreciating, the solution for competitiveness is to cut real wages. The claim appeared in an article in the Business Spectator on October 22 by business commentator Alan Kohler, who said:

The only sustainable response to a rising currency is to lift productivity and reduce real wages so that export industries can continue to compete … As Australia raises interest rates it must come up with another, better, way to deal with Dutch disease (which is the name given to what happens when something good causes a nation’s currency to rise, making its industry less competitive). Alternatively, and more likely, we could just leave the market to sort it out – by reducing employment and lowering wages among the exporters and raising them among the importers.

First, when there is an external cost shock (so an imported raw material rises in price), the national economy faces a real loss of income. This has to be shared out in some way among those who stake claims in real output. An equitable sharing arrangement would prorate the losses amonst profit margins and real wages. However, it is this sort of struggle that can provoke a wage-price struggle which may eventually manifest as inflation and depending on how the government manages the distributional struggle – as stagflation.

Second, when a currency is appreciating, you get sectoral effects with the traded-goods sector which is what the term Dutch disease refers to. This problem came up continually in my meetings this week because most of the CAREC countries are commodity exporters. The Australian problem is typically that mining booms and pushes the dollar up but the same global demand bouyancy is not enjoyed by agriculture anf manufacturing (both who also export). The latter two are then disadvantaged by the higher foreign price for their exports but no change in domestic (AUD) costs.

Productivity boosts will reduce real unit costs in those industries that enjoy it as will real wage cuts. But there are several problems with advocating this. How do you actually engineer real wage cuts in sectors which lose competitiveness? It is unlikely that you can cut nominal wages so you have to rely on inflation outstripping nominal wages growth. Given the mining boom, nominal wages growth in that industry will continue to outstrip average growth. You are then faced with suppressing nominal wages growth in agriculture and manufacturing.

Further, the import sector will start attacting labour (as Kohler notes) and the disadvantaged export sectors (not including mining) face labour supply shrinkages. The changing terms of trade also promote dynamic efficiencies (productivity growth) in the areas that are facing cost squeezes.

It is not an easy problem to develop effective policy unless you want to propose significant interventions in the market via incomes policy etc. I will write more about the Dutch disease in another blog because there is too much to say and I have done my time today.

Digression: Google ads:

While reading the Melbourne Age or any WWW site that plugs into Google Ads you get ads served that are targetted on the geographic area you are gaining access to the Internet from. So today, the Melbourne Age page is littered with English versions of ads for Kazakhstan.

Finally, signing off from Almaty …

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    2 Responses to Current accounts and currencies

    1. Keith Newman says:

      Mr. Mitchell; A very interesting blog today.
      I am also very interested in your upcoming comments on “Dutch Disease”. Despite being a very wealthy country many people in Canada are facing (relative) hardship. The Canadian dollar has appreciated considerably due to energy and mining exports and most manufacturing industries have suffered as a result. Of course some sectors of manufacturing have been badly affected by other factors as well, in particular reduced demand in the USA (e.g. building products, paper, auto parts), but appreciation of the currency has made matters worse and caused many Canadian plants to become “the marginal plants” in the North American market.

      There has been considerable talk of the Bank of Canada intervening in currency markets to stop appreciation, including warnings by the governor of the Bank himself to that effect. The warnings are credible since the Bank can create any number of fiat Canadian dollars to buy US dollar thereby reducing the value of the Canadian currency. Indeed the warnings seem to have been temporarily effective as the Canadian dollar dropped 2-3% following the warnings.

      Nonetheless this is not entirely satisfying. Reducing the value of the Canadian dollar increases the cost of many imported products including food and oil and natural gas, so it amounts to a tax on all Canadians to benefit exporters. In addition it makes energy and mining even more profitable, inducing increased output there, putting more upward pressure on the currency as they account for a large percentage of net exports. It also increases the cost of imported capital goods, hence discouraging investment.

      While one could argue it might be better to allow the dollar to appreciate and provide generous programs to help people and their communities to adjust and establish more productive industries, our federal government refuses steadfastly to provide such assistance in any adequate way. In addition, often the geographic distribution of the industries is such that it is far from clear what would replace them. For instance it is unrealistic to believe that sawmills in one-or-two-industry rural communites can be replaced by some highly productive tech industry.

      Clearly I look forward to your upcoming blog on this dilemma.

    2. Andrew says:

      In those situations, a country requires foreign goods and they need to export to get hold of foreign currency or receive development assistance from the rest of the World. In the latter case, I see a fundamental change is required in the role of the IMF (more or less back to what it was intended to do in the beginning). Where are country is facing continual current acccount and currency issues as a result of the need to import essential goods and services, the IMF might usefully act to maintain currency stability for that country.

      Do you mean by providing them with foreign exchange reserves for purchasing imports?

      Do you advocate capital controls and domestic financial regulation to stabilise the exchange rate?

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