Thursday, April 16, 2015

New-Old Paper on the Balance of Payments

Four or five years ago, I wrote a paper arguing that the US current account deficit, far from being a cause of the crisis of 2008, was a stabilizing force in the world economy. I presented it at a conference and then set it aside. I recently reread it and I think the arguments hold up well. If anything the case that the US, as the center of the world financial system, ought to run large current account deficits indefinitely looks even stronger now, given the contrasting example of Germany's behavior in the European system.

I've put the paper up as a working paper at John Jay economics department site. Here's the abstract:
Persistent current account imbalances need not contribute to macroe- conomic instability, despite widespread claims to the contrary by both mainstream and Post Keynesian economists. On the contrary, in a world of large capital inflows, a high and stable level of world output is most likely when the countries with the least capacity to generate capital inflows normally run current account surpluses, while the countries with the greatest capacity to generate capital inflows (the US in particular) normally run current account deficits. An emphasis on varying balance of payments constraints is consistent with the larger Post Keynesian vision, which emphasizes money flows and claims are not simply passive reflections of “real” economic developments, but exercise an important influence in their own right. It is also consistent with Keynes’ own views. This perspective helps explain why the crisis of 2008 did not take the form of a fall in the dollar, and why reserve accumulation in East Asia successfully protected those countries from a repeat of the crisis of 1997. Given the weakness of the “automatic” mechanisms that are supposed to balance trade, income and financial flows, a reduction of the US current account deficit is likely to exacerbate, rather than ameliorate, global macroeconomic instability.
You can read the whole thing here.



22 comments:

  1. My borrowing is beneficial to the rest of the world in a small way. It does not mean I can keep borrowing. Households as a sector can borrow a lot (have high net borrowing) and it's good for the economy and themselves. But it can become unsustainable.

    In other words, unsustainable processes may be coincident with rising output. So it's both good and bad.

    But you are extrapolating the rising output part to somehow argue that unsustainable process can become sustainable!

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  2. But you are extrapolating the rising output part to somehow argue that unsustainable process can become sustainable!

    No, I don't believe I am. Did you read the paper?

    Also, what do you mean by "sustainable"?

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    1. Sustainability is about stock-flow ratios. It can be good as well. Such as rising net international investment position/gdp (such as for exporting nations). So rising stock/flow norms may indicate unsustainable processes.

      "Did you read the paper?"

      If you make huge claim like "ought to run large current account deficits indefinitely" why do I need to read ;-)

      So I take it that the deterioration of the US net international position/gdp is of no worry at all to you. How much can it go? 100%?

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  3. Australia's net IIP is -220% of GDP and the US's is -40%. We don't know what the limit is for the US but surely it is not close to the limit. So, the US can run a C/A deficit for a very long time.

    Srini

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    1. Sorry wrong data.

      Australia's NIIP is minus 65%

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    2. We don't know what the limit is for the US but surely it is not close to the limit. So, the US can run a C/A deficit for a very long time.

      That's right. Furthermore, by far the most important driver of changes in the US IIP is price and exchange rate changes, not financial transactions. Two years ago, the US IIP was -28%, now it is -40%. Is this a sign of a huge increase in US borrowing from the rest of the world? Not at all -- it's entirely the result of the rise in value of the dollar and the US stock market boom, both of which raise the value of US liabilities to the rest of the world.

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    3. While you are right, asset revaluations both both due to change of the value of the dollar and without it is important, it does not mean that the current account deficit is irrelevant as you put it.

      According to your reason, it shouldn't matter if every year the CAD is 15%.

      Hilarious reasoning. Plus you quote the commenter who gives incorrect data.

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    4. And such analysis was carried out before the crisis by many authors.

      The relevant equation is:

      NIIP at the end of a period = NIIP before the period + CAB + Asset Revaluations.

      That's simplified as one has to look at gross asset and liability positions as well.

      If you make some assumptions about revaluations, you could say that maybe for a while, the net asset position won't deteriorate but soon the flow part will overtake the effects of the revaluations part.

      But such considerations don't seem relevant to you.

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    5. My bad. I did not annualize the quarterly GDP data for Australia. In any case, that still does not gainsay my point. In the last 50 odd years, Australia has run a current account deficit in all but a handful of years. It has actually not run a current account surplus since 1975. So, is Australia in an unsustainable position? What relevance does it have for any policy?

      Besides, the US is in a very different position compared with Australia. World over people demand US dollars in a crisis, even when the epicenter of the crisis is in the US as in 2008. What does that tell you? It tells us that the the US dollar is far, far, far from oversupplied, far from the point where unsustainability begins to bite.

      Also, currently, US balance of income is actually significantly positive.

      Ramanan, I respect where you are coming from--Kaldor, Godley, etc.--as opposed to the completely wrong-headed Reinhart-Rogoff stuff, but to me this sounds a little bit like people who were worried about US public debt in 2010.

      Srini

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    6. Srini,

      Any nation can run current account deficits forever.

      That sounds contradictory to everything I am saying right. Nope. A nation in deficit is imposed a constraint on its growth because of balance of payments.

      In other words, I am not arguing that every country which has a net indebtedness is unsustainable. It is about how much this is a case. One can easily construct sustainable positions with net indebtedness. Such as net indebtedness converging to 80% of GDP.

      So an analysis should highlight growth paths and the consequences of debt.

      You are right that the primary income balance is in the United States' favour and it is a good thing. The US can at present take the lead and do a fiscal expansion and take a hit on its current account deficit and it will be good for the world as a whole. But you also have to worry about what to do with what comes with it, how to improve its deficit and so on.

      One cannot arbitrarily claim that the US "ought to run large current account deficits indefinitely". A sustainable path is the one in which all the three balances move toward zero without hurting growth. Else it hurts growth. You can work out a policy in which it is not the case in the near term but you have to come up with something which changes this in the not-so near term.

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  4. It's not really meaningful to talk about sustainability and current account imbalances in such broad terms.

    Think in these terms:

    1) can the borrowers service their debts, regardless of the nationality of the owner.

    2) Is the debt subject to additional risk (e.g. currency risk), because a portion of it is held by foreigners.

    3) Is there any rollover risk?

    2) is a non-issue for U.S. debt. 3) is also a non-issue at the aggregate level, because failure to roll-over the debt means increased U.S. exports, which increases the income necessary to service the debt. So it really boils down to 1) which has *nothing* to do with the passport of the holder of the debt, and everything to do with the attributes of the borrower.

    It is a fair question to ask whether U.S, households are borrowing too much. It is a nonsensical question to ask whether U.S. households are borrowing too much from those with brown eyes or foreign accents.

    The problem of the developing nations is a shortage of low risk assets in relationship to savings demands in those nations. That savings demand is very high because of domestic oligarchs who have more or less inelastic savings demands and desire safety. The U.S., on the other hand, has a large concentration of low risk assets. primarily government and mortgage debt, but also relatively high quality corporate debt in comparison to the quality of public and private debt available throughout the world.

    It makes perfect sense, and you would expect, that the rest of the world would prefer to store a portion of its financial wealth as claims on U.S. debt, and that this process would continue at least up until the rest of the world is able to produce high quality debt of its own in sufficient quantity to meet the (obscene) demand for savings arising from (obscene) levels of global wealth inequality. That is the real limit or capacity on IIS. Should this capacity be reached, U.S. firms will have an export boom and this will increase the income of U.S. households, making it easier for everyone to service their debt in general, and making debt service to the rest of the world easier as a special case.

    On the other hand, just because something is not financially constrained doesn't make the current account deficit, which is driven primarily by wage arbitrage, a good thing for U.S. workers. It's terrible for both U.S. and foreign workers, but is unfortunately sustainable for a very long time to come.

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    1. This comment has been removed by the author.

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    2. I basically agree with all of this. A couple additions/amendments:

      Is the debt subject to additional risk (e.g. currency risk), because a portion of it is held by foreigners.

      I would add, either as a subset of this or an additional point, the question of whether the central bank (or some other entity) can prevent a cascade of defaults (or a fear of defaults limiting the extension of new credit) by issuing its own liabilities as necessary to ensure that debt contracts are fulfilled. The problem with debt owed in foreign currencies is not just that its local-currency value can vary with exchange rate movements -- after all, the same problem exists for units with domestic currency liabilities but foreign-denominated income. It is that foreign-denominated debt cannot be guaranteed by the central bank. But again, this is not a problem for the US.

      The rest of what you write is exactly right. Except that I am not sure the situation is unequivocally

      terrible for both U.S. and foreign workers

      you really have to specify the counterfactual. With respect to foreign workers, the first-best option would be a more equal distribution of income, which would, as you say, largely eliminate the private demand for US assets, plus a system of capital controls that would insulate Korea from destabilizing portfolio flows. But I think the current situation of large current account surpluses and reserve accumulation is still preferable to a situation where Korea was forced to make large interest-rate and income adjustments in response to shifting portfolio flows. With respect to American workers, I don't think the current account deficits necessarily need to be costly at all. In principle, there is no reason that the foreign inflows couldn't finance sufficient public spending to yield full employment here. If the spending was on some global public good like alternatives to fossil fuels, the situation wouldn't even be all bad for the rest of the world.

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    3. "whether the central bank (or some other entity) can prevent a cascade of defaults (or a fear of defaults limiting the extension of new credit) by issuing its own liabilities as necessary to ensure that debt contracts are fulfilled."

      Isn't this essentially what the primary dealer system accomplishes for USG debt (in a convoluted institutional way)?

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  5. According to your reason, it shouldn't matter if every year the CAD is 15%

    No, it's really not. I suppose it is unreasonable to expect everyone to read a 40 page paper, and I should post a summary here, and maybe I will. But I'm not saying that. I am saying that there is strong reason to believe that deficits on the scale actually run by the US have been a stabilizing rather than destabilizing force, and that under current conditions a move toward smaller US deficits would exacerbate the risk of future crises.

    It is silly to argue that because something can't get arbitrarily large, it shouldn't increase at all, that it must go to zero.

    If you make some assumptions about revaluations, you could say that maybe for a while, the net asset position won't deteriorate but soon the flow part will overtake the effects of the revaluations part.

    You can assert this all you want but it isn't true. And it's especially not true for the US, because our liabilities are almost all dollar-denominated, while a large fraction of the credit items in our balance of payments are linked to foreign currencies. Any flight from US assets would cause a depreciation of the dollar, which would shift the IIP back toward net credit. Because of this, there is literally no mechanism that could create BoP problems for the US, until and unless US foreign liabilities come to be denominated mainly in foreign currencies. This is not the position of most other countries in the world.

    A sustainable path is the one in which all the three balances move toward zero without hurting growth. Else it hurts growth.

    How? Why? This sounds like Reinhart-Rogoff on public debt.

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    1. "[me] According to your reason, it shouldn't matter if every year the CAD is 15%

      No, it's really not. I suppose it is unreasonable to expect everyone to read a 40 page paper, and I should post a summary here"

      My statement was about the analysis how net indebtedness would move. Your paper does not have anything about it. As I said, true revaluations creates complications but you can't handwave and say the US has to run large current account deficits.

      While your point remains, that the CAD is beneficial, but sustainability is a different question. It is difficult to see this in an open economy but in a closed economy one can think of a sector such as households having large negative net lending and this raising output and creating a boom. But it can end in a bust.

      "You can assert this all you want but it isn't true."

      It is not me, who is asserting. You are simply dismissing the CAD as non-contributing. It contributes but its effects are compensated by revaluations. This however is true only for small net indebtedness.

      Again you need numbers to say this. That US liabilities is denominated in dollars is an important thing but it doesn't change the analysis too much for you to completely ignore the effect of CAD.

      You are just exploiting the effect of large revaluations. Suppose that US corporations were to not make large appreciation of their assets. That changes your analysis. Is your analysis so sensitive that this complication MUST be present?

      The best way is to write a model and check for yourself. Your 40-page paper does not do that.


      "How? Why? This sounds like Reinhart-Rogoff on public debt."

      So indebtedness to foreigners is irrelevant? RR's error is to think of the public debt rather than indebtedness to foreigners. Their prescription is a fiscal contraction. Nothing like what I susbscibe to: which is an expansionary fiscal policy, at least coordinated at an international level and also policies for balance of payments targets. Public deficits in such scenarios more toward zero not as a result of contractionary policies but due to a rise in output bringing in more taxes to governments.

      Btw, that three balances moving toward zero is also the approach of Wynne Godley. I will try to find the relevant passage from his strategic analysis.

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    2. And of course move toward zero in the long run, not short run.

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  6. Ramanan, can you explain the mechanism by which a negative IIP should lead to slower growth?

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    1. The answer is not straightforward. A nation can grow fast while its net indebtedness is deteriorating because foreigners do not mind.

      But a negative NIIP is both a symptom and a problem by itself. It is a problem because it (the absolute value, if NIIP is negative) is the net indebtedness of the nation and interest is paid to foreigners.

      It is a symptom of a problem because domestic demand cannot be raised fast, else the indebtedness will grow.

      The balance of payments constraint is a debt constraint.

      For the US complications arise because the net primary income is in the US' favour despite being a debtor nation. This however doesn't mean that there is no issue because if the debt grows to a "tipping point" (terminology of Gourinchas and Rey), this will turn negative.

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  7. Interesting article. Answers a lot of my concerns from the last post. A couple random thoughts.

    1. Germany and Japan really look awful in this analysis.

    Though it might be good for the us to run a CA deficit, is it really a good thing when Germany, Japan, Oil Exporters and China are the main surplus countries?

    2. It was surprising to me how much income dominates the price effect. But it still isn't clear to me what happens when exchange rates move.

    For the past year, the USD has been appreciating against the EUR, so does this not matter. From an income growth standpoint, The US should be importing more and EZ less, which is what we see. But if we combine this with the exchange rate move, the profitability of a lot of the trade should be being captured on the US side. This is not what is being reported in the news where the EUR/USD moves are presented as good for EZ corporations and bad for US corporations.

    So why do countries peg exchange rates and then defend any pressure to appreciate in the market? If income dominates trade they are just causing a loss of profitability in their exporting sectors.

    3. Political constraints on foreign ownership will be the ultimate constraint. Piketty talks a lot about this. What is the foreign ownership percentage of Australian assets?

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    1. Germany and Japan really look awful in this analysis.

      Yes, they do.

      it still isn't clear to me what happens when exchange rates move.

      Empirically, it does not seem to be the case that country with a depreciating currency reliably sees an improving trade balance. Certainly not over a horizon of a year or less.

      So why do countries peg exchange rates and then defend any pressure to appreciate in the market?

      Exchange rate volatility is pretty clearly costly for countries whose economies are highly integrated with the global system by whatever channel (trade, income flows, foreign investment).

      Political constraints on foreign ownership will be the ultimate constraint.

      Perhaps. On this point I think its very worthwhile to study the gold standard/imperialism era of the 1870s up to World War I.

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