Do US Trade Deficits Result In “Net Profits” For The US?

It’s frequently claimed that the US 🇺🇸 has trade deficits but since the US dollar has not collapsed, the ones saying that the US does not have a balance of payments constraint are all wrong.

Now there are several errors in this line of reasoning but going straight to the point: the balance-of-payments constraint is first a constraint on output. There’s a deflationary bias in the US output because of the imbalance in trade.

This article is written in response to a blog post Cumulative U.S. Trade Deficits Resulting in Net Profits for the U.S. (and Net Losses for China) at the blog macroblog by the Federal Reserve Bank of Atlanta. The article says:

The United States has run trade deficits for decades (1976 is the last year with a recorded surplus). To illustrate this, chart 1 depicts the cumulative U.S. trade deficit since 1980, which now surpasses $10 trillion. As a result, a drastic deterioration in the U.S. net foreign asset position—the difference between the amount of foreign assets owned by U.S. residents and the amount of U.S. assets owned by foreigners—has occurred. That is, as Americans borrow from the rest of the world to finance the recurring trade deficits, the national net worth goes deeply into the red. Not long ago, many commentators predicted that as a result of this increasing U.S. foreign debt, the U.S. dollar was set to collapse, which would trigger a stampede away from U.S. assets. Of course, this has not happened.

The wording of this itself is problematic. First some definitions:

Here’s from the IMF’s Balance of Payments And International Investment Position Manual (BPM6), pg 9:

The balance of payments is a statistical statement that summarizes transactions between residents and nonresidents during a period. It consists of the goods and services account, the primary income account, the secondary income account, the capital account, and the financial account. Under the double-entry accounting system that underlies the balance of payments, each transaction is recorded as consisting of two entries and the sum of the credit entries and the sum of the debit entries is the same.

What the US has is a positive balance in the secondary income account (more credits than debits) despite running large deficits in the primary account and despite having a large negative net international position. But “net loss” or “net profit” is bad wording to start with. Also the net international investment position itself is not “national net worth” because the latter includes non-financial assets owned by resident economic units and hence doesn’t make an appearance in the international investment position.

Now coming back to the point on output – If the US economy were to run under full capacity at all times with the current account deficit widening and the net international investment position deteriorating relative to gdp without limit, it can then be claimed that the US doesn’t have this problem and the economists worrying about US trade got it all wrong. But that is far from the case. Not only is the US economy not running under full capacity, but so much output has been lost since the beginning of the crisis starting in 2007.

Having an imbalance in trade means that output multipliers aren’t as high as it would have been the case otherwise. So the government expenditure multiplier and private expenditure multiplier are inversely related to the propensity to import and would have been higher if the propensity to import were less.

Usually economists talk about either trade or the financial aspect (i.e. either the current account or the financial account of the balance of payments) but not both together in a single unified framework. Most of the conclusions reached are due to lack of analysis which treat both of them simultaneously. Stock flow consistent models are an exception but other models are so messed up even for the closed-economy that it’s difficult in those models to make progress.

The fact that the US secondary income is in the US’ favour has led economists to draw any conclusion they want from their analysis. Let’s touch one aspect – the tipping point.

The tipping point

Let’s say you have assets worth $100 and earning at 6% annually (such as interest or dividend), and liabilities of $110 paying at 5%. So even though your liabilities are higher than assets, your income on assets ($6) is higher than what you pay on your liabilities ($5.5). So far, so good, so what? While this is not a bad situation, this is unlikely to remain the case forever. For example if your assets stay the same whereas liabilities rise to $130, then the net income is against your favour. You are earning $6 per year but paying $6.5.

The point of the above example is that even though the US earns more on assets held abroad than what it pays nonresident economic units on their financial assets, this process cannot continue forever. Sooner or later, the difference between the assets and liabilities (because of continuous trade deficits) will be so high that the secondary income in the current account in the balance of payments will be negative. So estimating the tipping point is estimating when this will happen.

Surely, if the US runs at full capacity and hence higher trade deficits because of higher national income and income effects on imports, the US will hit the tipping point sooner. At that point nobody can obfuscate the debate by saying that the secondary income balance in the current account of the balance of payments is positive. The international investment position will deteriorate at a much faster rate.

Of course reaching the tipping point itself is not apocalypse. Some countries do have a negative balance in the secondary income account of their balance of payments. The situation can continue as long as markets allow it to go on. When the busts, it will create a problem but nobody has a theory yet on when exactly some busts, although we’ve made progress on identifying unsustainable processes.

The point of the above analysis is that none of the arguments trying to claim directly or implicitly that “current account deficits do not matter” are erroneous.

No, the dollar won’t collapse but the US economy will run from full capacity to keep debts in check. Such as so much lost output in the last 9 years or so. To summarize, there are at least two scenarios here which are either confused or conflated or both by economic commentators:

  1. The US economy running closer to full capacity but with international investment position deteriorating fast and a threat to the US economy and the currency.
  2. Status-quo, where there’s deflationary bias to the US economy and hence consequences to output, employment and income for the bottom of the population but no immediate threat to the international investment position (although deteriorating) and in which there’s no dollar collapse.

The empiric of scenario 2 above cannot be used to argue that scenario 1 is benign because these two are different states of the world.

The solution is another scenario, a scenario 3 in which output is raises by fiscal expansion but the US government also works to address its balance of payments problems. For example, China’s strategy of exports is quite damaging to the US economy and it is important that the US establishment addresses this instead of just saying “it does matter” or that market mechanism will do the trick.

Last updated 15 Oct 2016, 1:21pm UTC – typo fixed. 

The UK’s International Investment Position

There’s one thing that slipped out of my mind in my recent post Sterling Flash Crash And The UK’s Balance Of Payments, i.e., the UK’s international investment position.

The Bank of England’s financial stability report from July has an interesting discussion on this with this chart.


UK’s net international position. Source: BOE.

with the comment:

The currency composition of the United Kingdom’s external balance sheet does not amplify risks associated with a sterling depreciation.

Currency mismatches in a country’s external balance sheet can amplify risks associated with a large current account deficit, if a depreciation of the currency leads to a deterioration of the external balance sheet position. Although there are no official statistics on the currency composition of the United Kingdom’s external balance sheet, estimates suggest that around 60% of the stock of external liabilities is denominated in foreign currency, compared with more than 90% of the stock of external assets. This means that, other things equal, a fall in the value of sterling should increase the value of external assets relative to liabilities, improving the United Kingdom’s net foreign asset position which was -6.7% of annualised GDP in 2016 Q1 (Chart A.11).

Of course, it is important to keep in mind that while this is true, large movements in liabilities in can affect corporations and systemic risks can arise if a large corporation fails. But at the same time, assuming risks are contained, the above is beneficial to the UK. Risks associated with Brexit and the fall in the value of the Sterling aren’t as bad as presented by economists 🤡 with the opinion that the UK should remain in the EU.

Ashoka Mody On How The Consensus Is Flawed Again

Ashoka Mody, a professor at Princeton and a scholar at Bruegel has a nice article Don’t Believe What You’ve Read: The Plummeting Pound Sterling Is Good News For Britain for The Independent.

He argues that a lower value for the Sterling will help rebalance the UK 🇬🇧 economy. Mody says:

It is true that with an overvalued pound, the British public could command more foreign goods and services with their currency. But British producers lost competitiveness at home and abroad. Producers’ incentives to invest were weakened, leading to Britain’s poor productivity performance. And that led to a large current account deficit.

and also that:

[The] “elite” group continues to hold the microphones of policymaking and its words reverberate through the financial press. All these years, however, the strong pound hurt job creation and investment in productivity growth. And those who have long been hurt don’t live in London and don’t hold the microphones.

Ashoka Mody also wrote a highly readable and excellent piece EU referendum: Why The Economic Consensus On Brexit Is Flawed before the EU referendum, which you should still read if you didn’t earlier. It was one of the most important pieces in the media before the referendum. It argued how issues such as fiscal constraction aka austerity were sidelined in the debate.

Another Admission

A few days back I posted a link to a paper written by a top advisor the US government admitting that economists in general got fiscal policy quite wrong before the crisis.

Now another admission, but this time from a non-orthodox economist.

In a recent blog post, Bill Mitchell writes (on reforming the international institutional framework):

2. Macroeconomic stabilisation – support for national currencies in the face of problematic balance of payments.

This function recognises that all nations should maintain sovereign currencies and float them on international markets but at the same time recognising that capital flows may be problematic at certain times and that some nations require more or less permanent assistance due to their export capacities and domestic resource bases.

The trouble with Neochartalism (Mitchell and his colleagues’ theory, also called “modern monetary theory” by themselves) is that what is correct is not original and what is original is incorrect. Despite repeated arguments of other non-orthodox economists, Neochartalists have continued to deny the existence of the balance-of-payments constraint. Still a long way to go from understanding the supreme importance of balance of payments on growth, but this is a good positive step.

It’s ironic that Neochartalists are followers of Hyman Minsky who talked of financial crises. While Neochartalists emphasize that crises can happen in financial markets, they have till now completely denied that it can happen in foreign exchange markets.

Neochartalists emphasize fiscal policy, as if problems start and end there. But the problems of this world can be solved not just by fiscal policy but also by industrial policy and in the international sphere via diplomacy.

Sterling Flash Crash And The UK’s Balance Of Payments

The European Union is founded on the principles of free trade. Dean Baker has a nice blog post on his blog Beat The Press titled, The Value Of The Pound Is Not A Measure Of The Success Or Failure Of Brexit. In that, he comments on Friday’s fall in the exchange rate of the Sterling.


GBPUSD post EU Referendum

Reuters has even confirmed a low of $1.1378.

The fall has been claimed to be a failure of the UK 🇬🇧 exiting from the European Union. Dean Baker, although seems to side with the remain-in-the-EU camp, points out:

The Brexit vote was a case where the elites were clearly aligned against the UK leaving the European Union. While they had many good arguments on their side, and much of what the pro-Brexit crew was saying was nonsense, some of the elite gloating now also falls into the nonsense category.

The reason I say this is that he seems to think that there is no economic argument for leaving, while in my opinion, it is quite the opposite. Anyway, I really liked him saying that the elites were aligned against the non-elites. Unfortunately the UK far-right jumped on to this – arguing for exiting the European Union, and it made it easy for the neolibs to thrash arguments for leaving the European Union.

Anyway, the reason for the post is that there’s a frequent claim made around the UK’s current account deficit and the exchange rate in contrast to Baker who says:

Rather than being a negative for the economy, this is a positive development. It is the only plausible mechanism through which the UK can get closer to balanced trade.

Somewhat funnily, the neolibs whose arguments are about the magic of the “market mechanism” are making arguments similar to heterodox economists’ elasticity pessimism. According to the elasticity pessimism view income effects far outweigh the price effects and the market mechanism does not resolve imbalances in balance of payments. The elasticity pessimism view doesn’t claim that price effects do not matter at all.

But funnily, the anti-Brexit people seem to use this view since it suits their political purposes and what’s interesting is that even taking the view that price effects aren’t there! So they are claiming that the exchange rate movement can’t improve the UK balance of payments. Now an analysis of how much exchange rate movements have affected the UK’s exports and imports is difficult but instead of taking an empirical approach, let me make some theoretical arguments.

The claim is that wide movement of exchange rates hasn’t improved the UK current account balance. But that doesn’t mean it doesn’t matter. It just means that the income effects have far outweighed price effects. The depreciation of the Sterling should help the UK. To illustrate my point imagine this (numbers are just for illustration, aren’t actual):

Scenario: The UK current account deficit rises from 7% of GDP in 2016 to 8% of GDP in 2017.

This 1% rise might be explained by:

  • 1.3% due to income effects: i.e. change in GNI at home and abroad, changes in non-price competitiveness.
  • minus 0.3% due to price effects i.e., changes in the exchange rate and changes in price competitiveness.

So just superficially looking at empirical data might lead us to conclude that the fall in the exchange rate of the Sterling has had no improvement, but that’s not the case. The fall has helped but income effects have outweighed. If the exchange rate hadn’t changed, the current account deficit would have risen to 8.3% of GDP.

But if the UK current account balance of payments doesn’t improve, what is the point of all this you may ask. Well, for one a depreciated exchange rate helps at the margin but the more important effects—which depend on trade negotiations—tariffs etc, would depend on how the UK government manages to help its domestic industry and improve its non-price competitiveness. Leaving the EU would also mean that the UK regulates migration and this would help improve wages, employment and output.

It’s an extreme view that price effects do not matter. China, for example has a highly undervalued exchange rate obtained by official management by PBOC, China’s central bank. Elasticity pessimists do not think that price effects do not matter, only that income effects matter more typically and that the market mechanism does not resolve imbalances. Elasticity pessimism is not an extreme view but it is ironic to see the neolibs who have argue in favour of a common market to take an extremized version of the elasticity pessimism view.

There is even more irony in this. Not joining the European Union was a respectable view in the 70s when Nicholas Kaldor used to argue against joining the EU. But in recent times, it has been hijacked by the nationalists making it easier for neoliberals to claim victory. They just have to argue how the nationalists are wrong (which is true) but it doesn’t mean that the neoliberal project is correct.

Lastly, does it not matter if a currency has a run. Of course it does matter. Just that the Sterling’s fall can’t be called that and the UK is not really in danger because of the fall in the exchange rate. There are no expectations building around the Sterling like what happens to third-world nations’ currencies many times.

Free Trade And Balanced Budgets

Wikileaks has released “The Podesta Emails” which show Hillary Rodham Clinton’s political positions best explained by an NYT article:

[Clinton] embraced unfettered international trade and praised a budget-balancing plan that would have required cuts to Social Security, according to documents posted online Friday by WikiLeaks.

The tone and language of the excerpts clash with the fiery liberal approach she used later in her bitter primary battle with Senator Bernie Sanders of Vermont and could have undermined her candidacy had it become public.

Neoliberalism, the “New Consensus” and pre-Keynesian economics stand exactly for this idea: free trade and balanced-budgets. John Maynard Keynes’ true followers starting with Joan Robinson stood exactly in dissent against the idea of free trade and balanced budgets. Keynes himself understood the trouble with free trade, as can be seen by reading his chapter on Mercantilism in the General Theory, but didn’t emphasize it enough. Unlike what others see, Joan Robinson stood for her opposition to free trade more than anything else.

According to the New Consensus of economics, fiscal policy is impotent and hence budget should be balanced. Free trade will lead to convergence of fortunes of nations according to this view. Instead what we see is polarization. In my previous post, I quoted a top advisor who conceded how economists had been wrong about fiscal policy. But the damage seems to have done. Progressive and Keynesian ideas have a long battle ahead.

Needless to say Donald Trump is not the alternative. So there’s a lot of fight ahead for economists in years ahead to overthrow the new consensus. Macroeconomics makes a difference in people’s life, and it’s a battle worth fighting.

Remarkable Admission On Fiscal Policy

There’s a paper by Jason Furman who is the Chairman of the Council of Economic Advisers which concedes how wrong economists were on fiscal policy. The link is a file hosted at the White House’s website! The paper starts off with a remarkable admission on fiscal policy (h/t and words borrowed from Jo Michell)

A decade ago, the prevalent view about fiscal policy among academic economists could be summarized in four admittedly stylized principles:

  1. Discretionary fiscal policy is dominated by monetary policy as a stabilization tool because of lags in the application, impact, and removal of discretionary fiscal stimulus.
  2. Even if policymakers get the timing right, discretionary fiscal stimulus would be somewhere between completely ineffective (the Ricardian view) or somewhat ineffective with bad side effects (higher interest rates and crowding-out of private investment).
  3. Moreover, fiscal stabilization needs to be undertaken with trepidation, if at all, because the biggest fiscal policy priority should be the long-run fiscal balance.
  4. Policymakers foolish enough to ignore (1) through (3) should at least make sure that any fiscal stimulus is very short-run, including pulling demand forward, to support the economy before monetary policy stimulus fully kicks in while minimizing harmful side effects and long-run fiscal harm.

Today, the tide of expert opinion is shifting the other way from this “Old View,” to almost the opposite view on all four points. This shift is partly the result of the prolonged aftermath of the global financial crisis and the increased realization that equilibrium interest rates have been declining for decades. It is also partly due to a better understanding of economic policy from the experience of the last eight years, including new empirical research on the impact of fiscal policy as well as observations of the reaction of sovereign debt markets to the large increases in debt as a share of GDP in the wake of the global financial crisis. In the first part of my remarks, I will discuss the theory and evidence underlying this “New View” of fiscal policy (with, admittedly, the core of this theory being an “Old Old View” that dates back to John Maynard Keynes and the liquidity trap).

Compare that to the Post-Keynesian view, which according to Wynne Godley and Marc Lavoie in their book Monetary Economics written before the crisis (from chapter 1, Introduction):

The alternative paradigm, which has come to be called ‘post-Keynesian’ or ‘structuralist’, derives originally from those economists who were more or less closely associated personally with Keynes such as Joan Robinson, Richard Kahn, Nicholas Kaldor, and James Meade, as well as Michal Kalecki who derived most of his ideas independently.

… According to post-Keynesian ideas, there is no natural tendency for economies to generate full employment, and for this and other reasons growth and stability require the active participation of governments in the form of fiscal, monetary and incomes policy.



An Undergraduate’s Question About Economic Policy: Thomas Palley Replies

Thomas Palley replying to a student:

Economics, like all social thought, is a contested space. Neoliberals have an interest in controlling economics since control helps them advance their political and economic project by helping them sell their policy ideas.

… I am a great fan of the student movement for change in economics.

Full email and reply in the link. The title of this page is the link.

James Tobin On Real Business Cycle Theory

Lars Syll has a nice post quoting James Tobin’s views on the real business cycle theory (and dynamic stochastic general equilibrium (DSGE) models. DSGE models are just RBC theory models with some modifications but still retaining the core).

There’s also another paper, An Old Keynesian Counterattacks by James Tobin written in 1992 and devoted heavily on attacking all this.

Tobin says:

The crucial issue of macroeconomic theory today is the same as it was sixty years ago when John Maynard Keynes revolted against what he called the “classical” orthodoxy of his day. It is a shame that there are still “schools” of economic doctrine, but perhaps controversies are inevitable when the issues involve policy, politics, and ideology and elude decisive controlled experiments. As a lifelong Keynesian, I am quite dismayed by the prevalence in my profession today, in a particularly virulent form, of the macroeconomic doctrines against which I as a student enlisted in the Keynesian revolution. Their high priests call themselves New Classicals and refer to their explanation of fluctuations in economic activity as Real Business Cycle Theory. I guess “Real” is intended to mean “not monetary” rather than “not false,” but maybe both.

I am going to discuss the issues of theory, Keynesian versus Classical, both then and now. Since the main purpose and preoccupation of macroeconomic theory is to guide fiscal and monetary policies, the theoretical differences imply important differences in policy. Moreover, prevailing doctrines seep gradually into the ways the world is viewed not only by economists but also by students, pundits, politicians, and the general public. It is in this sense but only in this sense that I shall be talking about current events.

The doctrinal differences stand out most clearly in opposing diagnoses of the fluctuations in output and employment to which democratic capitalist societies like our own are subject, and in what remedies, if any, are prescribed. Keynesian theory regards recessions as lapses from full-employment equilibrium, massive economy-wide market failures resulting from shortages of aggregate demand for goods and services and for the labor to produce them. Modern “real business cycle theory” interprets fluctuations a moving equilibrium, individually and socially rational responses to unavoidable exogenous shocks. The Keynesian logic leads its adherents to advocate active fiscal and monetary policies to restore and maintain full employment. From real business cycle models, and other theories in the New Classical spirit, the logical implication is that no policy interventions are necessary or desirable.

Should we describe the macro-economy by two regimes or one? The old Keynesian view favors two regimes. In one, the Keynesian regime, aggregate economic activity is constrained by demand but not by supply. If there were additional effective demands for goods and services, they could be and would be satisfied. “Demand creates its own supply.” The necessary inputs of labor, capital capacity, and other factors are available, ready to be employed at prices, wages, and rents that their productivity would earn. Only customers are missing.

The second regime, which Keynes called classical, is supply-constrained. Extra demand could not be satisfied at the economy’s existing capacity to produce. The needed workers or other inputs are not available at affordable wages and rents. The supply limits bring about prices and incomes that restrict aggregate demand to capacity output. Should capacity increase, those prices and incomes will automatically generate just enough additional purchasing power to buy the extra output. “Supply creates its own demand.”

Keynesians believe that the economy is sometimes in one regime, sometimes in the other. New Classicals model the economy as always supply-constrained and in supply-equals-demand equilibrium. In their real business cycle models, the shocks that move economic activity up and down are essentially supply shocks, changes in technology and productivity or in the bounty of nature or in the costs and supplies of imported products. Although external forces of those kinds, for example weather, harvests, natural catastrophes, have been the main sources of fluctuating fortunes for most of human history, and although events continually remind us that they still occur, Keynesians do not agree that they are the main source of fluctuations in business activity in modern capitalist societies.

and in the end concludes by asking:

Why do so many talented economic theorists believe and teach elegant fantasies so obviously refutable by plainly evident facts? Trying to answer that question would take us into a speculative excursion on the sociology of the economics profession, beyond the scope of this paper.