Tag Archives: balance of payments

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. 

Milton Friedman On Free Trade

I always like watching Milton Friedman, not because I like him but for something totally opposite. It helps in knowing what the exact position of economists is. Milton Friedman has been hugely influential on how economists think. Almost everyone is just rambling what Friedman said, so why not listen to their master?

This is a lecture given in 1978 on free trade.

Milton Friedman Lecture On Free Trade

click the picture to watch the video on YouTube

A claim made by Friedman in the video is that market mechanisms work to resolve balance of payments problems. “Balance of payments is not a problem”, says Friedman. Of course that’s all wrong but economists continue to believe in such things.

Another claim made by Friedman is that protectionism is because few industries lobby for it. While that is certainly true, how about “free trade” itself? Producers with market share in international markets influence their governments to push for free trade internationally. Why didn’t he talk of those things?

Output At Home And Abroad

It’s fairly common for economists to confuse accounting identities and behavioural relationships.

Question: What is the best way to find it?

Answer: The behaviour of output (at home and abroad) is not discussed in their analysis.

It’s not always the case that it’s true but a good way to find – check whether the economist is talking of the effect of changes in stocks or flows on output.

It’s also of course important to discern what someone is literally saying and what that person is trying to say. Economists aren’t the best communicators. For example, consider the sentence: “(fiscal) deficits increase growth and surplus reduces it”. This is far from accurate because the fiscal deficit is an output of a model (and everyone has a model implicitly), not an input. It’s better to state whether the fiscal policy under discussion is expansionary or contractionary. So let’s say that private expenditure rises relative to income for whatever reason, such as expectations of the future. This leads to a rise in output and hence taxes and the fiscal deficit will reduce and we have a rise in output coincident with a fall in fiscal deficit. But neither fiscal deficit or surplus caused that growth. At the same time, one should also try to check what the narrator is trying to say. So if someone says “deficit spending is needed”, he or she is actually trying to say, “an expansionary fiscal policy is needed”.

It doesn’t harm to be accurate or try to be accurate.

One of the worst mistake of this kind being discussed is using the identity (in the case of a closed economy):

G − T = S − I

where G, T, S and I are government expenditure, taxes, private saving and private investment respectively.

A careless look at this would led one to conclude that “deficits reduce investment”. What the economist who claims this is saying is that an fiscal expansion (rising government expenditure and/or reduced tax rates) decreases investment. The error in this is that, saving is thought to be constant. However, using a Keynesian stock-flow consistent model, it is not difficult to see that a fiscal expansion has an expansionary effect on output which will raise private investment and also private saving (assuming saving propensities are constant).

More generally, the equation is:

G − T + CAB = S − I

in the general case of the open economy. In the above CAB is the current account of the balance of payments. Also balance of payments accounting tells us that current account balance is equal to the net lending to the rest of the world. In the old balance of payments terminology, this is equal to the negative of the capital account balance.

So we have:

CAB + KAB = 0



in the modern balance of payments terminology, where NL is the net lending of resident economic units to the rest of the world.

This has led to various theories about how what causes trade imbalances. A careless conclusion which can be drawn by looking at the last equation is that an increase in private saving or a reduction in the government expenditure reduces the trade balance. Although in this case it’s true, this happens via a reduction of output.

Another strange hypothesis is to say that it’s net borrowing (the opposite of net lending) from the rest of the world which causes current account deficits. Some authors such as Michael Pettis have taken this to extreme.

Wynne Godley was one economist who made heavy use of the accounting identity.

G − T + CAB = S − I

In his view, the causal relationship linking the balances is via output at home and abroad. 

In his 1995 article, A Critical Imbalance in U.S. Trade he says:

… an accounting identity, though useful as a basis for consistent thinking about the problem can tell us nothing about why anything happens. In my view, while it is true by the laws of logic that the current balance of payments always equals the public deficit less the private financial surplus, the only causal relationship linking the balances (given trade propensities) operates through changes in the level of output at home and abroad. Thus a spontaneous increase in household saving or a spontaneous reduction in the budget deficit (say, as a result of cuts in public expenditure) would bring about an improvement in the external deficit only because either would induce a fall in total demand and output, with lower imports as a consequence.

In this post, I want to highlight how capital flows can impact trade balances using my experience with experimenting with stock flow consistent models. Before that, it’s important to note a few things which are often forgotten.

An import by a resident economic unit is a decision to purchase a good or a service produced by a non-resident producer. Similarly exports of a nation is indicative of the relative competitiveness of producers at home in international markets. It cannot be said to be caused solely by capital flows. But it’s not so simple. Imports for example depend on incomes of resident economic units and capital flows can have an impact on imports because they can affect output and income.

But it’s vacuous to say that current account imbalances are caused solely by capital flows as many economic commentators claim implicitly or explicitly.

It’s easy to commit the mistake and think that imports depend solely on prices of goods and services.  The world is not so simple. If every good or service is exactly the same, then it’s all about prices. However, producers produce thousands of different goods and services. So both price and non-price factors matter in determining imports. Even for similar goods, such as cars, consumers tend to prefer foreign produced cars over domestically produced ones even if the former is much more expensive simply because consumers are not just looking at the price but also quality, durability, looks and design and so on.

So both price competitiveness and non-price competitiveness are important. The way these things are modelled in literature is by using price and income elasticities. Imports depend on price via terms involving price and price elasticities and on income via terms involving income and income elasticities.

Where can we then look for causal connection of impact of capital flows on trade balance?

Before this it is important to keep in mind that gross capital flows can be compensated gross flows in the other direction. So to look for a causal connection in the accounting identity:

NL = CAB (or “CAB + KAB = 0″)

is silly to begin with.

So here are some ways in which capital flows can cause have an impact on trade balances.

  1. Capital flows cause exchange rates to move. With floating exchange rates, the exchange rate is the price which clears the supply and demand for assets of currencies. Note, in a correct model of exchange rates, supply and demand for all assets should be included not just “money” or “currency”. Exchange rate movement impact prices of goods and services. Since imports and exports depend on prices of goods and services (among other things), capital flows impact trade balance. It’s of course important to keep in mind producers’ own pricing behaviour: If the Japanese Yen appreciates by 30% against the US dollar, it’s not necessary that Japanese producers will raise prices of their goods in the U.S. market by 30%. They might raise the price only by 10%. But this is a digression, the important point being that capital flows cause changes in prices of imports and exports and hence the trade balance.
  2. Long term interest rates are both due to expectations of short term interest rates and portfolio preference for assets such as government bonds with long maturities. Long term Interest rates have an effect on aggregate demand which has an effect on output and income and hence imports.
  3. Capital flows can cause asset price booms, such as a stock market boom and via the wealth effect, cause changes in output and income and hence imports.
  4. There’s a further complication. Suppose there’s a large capital inflow into equities. This can cause switch of resident holders of equities (issued by resident economic units) into newly produced houses. This has an effect on aggregate demand and output and hence income and imports. This mechanism is slightly different from the wealth effect in point 3. It’s more a flow effect. Also in my opinion, it’s not easy to model this because one has to keep in mind gross capital outflows in balance of payments as well.
  5. Purchase of new houses by non-residents: Depending on regulations in the land, foreigners can directly purchase houses – such as a vacation house in Greece or to speculate on house prices such as in London. There can even be foreign investment funds which can speculate by buying houses and commercial property. This has the effect on aggregate demand and output and income and hence imports.
  6. Securitization allows banks to package loans on their balance sheet and sell it to investors. This allows banks to reduce risks and because of this they can make more loans which they may not have made without securitization. More lending means higher aggregate demand and output and income and affects imports.
  7. Direct investment: Direct investment is a more complicated example. Direct investment can raise output by various means, such as causing rising business domestically, employing people. They not only have an effect on the trade balance because of their international nature but also because their profits affect balance of payments. Also one has to be careful: sometimes direct investment is confused with the in the identity: G − T + CAB = S − I. Needless to say, this is confusing the different meanings of “investment”.
  8. Large capital outflows can cause a large depreciation of the currency and impact a nation’s fiscal policy. If there are large gross outflows, a government may be forced to deflate domestic demand and output to reduce imports. The flip-side is that large capital flows can keep a bubble from busting for long.

On Twitter, T Srinivas mentioned to me that desire to accumulate reserves may cause nations to depress demand and hence lead to lower exports for other nations, citing the example of events following the Asian Crisis in the late 90s. This is partly included in 8. Although I don’t disagree, my points are more about flows caused due to changes in investor preferences themselves.

Of course it touches an important point. Low domestic demand and output in “surplus” nations leads to a positive net lending to the rest of the world. It’s more accurate to say that the current account deficit of “deficit” nations is because of low domestic demand and output than because of capital inflows to those “deficit” nations. So it’s not “saving glut” but demand shortage, beggar-my-neighbour policies.

In conclusion it is counterproductive to use the accounting identity


(or the same identity in the slightly misleading language CAB + KAB = 0) to claim a causation from capital flows to current account balance.

An example is this paragraph from Michael Pettis:

… This is one of the most fundamental errors that arise from a failure to understand the balance of payments mechanisms. As I explained four years ago in an article for Foreign Policy, “it may be correct to say that the role of the dollar allows Americans to consume beyond their means, but it is just as correct, and probably more so, to say that foreign accumulations of dollars force Americans to consume beyond their means.” As counter-intuitive as it may seem at first, the US does not need foreign capital because the US savings rate is low. The US savings rate is low because it must counterbalance foreign capital inflows, and this is true out of arithmetical necessity, as I showed in a May, 2014 blog entry.

It’s an extreme viewpoint. During the crisis, there was a large foreign demand for US public debt but this didn’t cause a rise in U.S. imports. Similarly, a central bank intervening in the foreign exchange market and buying U.S. dollars from U.S. resident economic units doesn’t cause U.S. imports to rise in the few seconds. (Accounting identities also hold for time periods of seconds!) It’s balanced by gross U.S. capital outflows.

Capital flows can impact trade balances but it has really nothing to do with this identity. The causal link is still output and home and abroad (and some due to price changes of goods and services due to exchange rate movements).

Nicholas Kaldor On The Foreign Trade Multiplier

This is the basis of the doctrine of the ‘foreign trade multiplier’, according to which the production of a country will be determined by the external demand for its products and will tend to be that multiple of such demand which is represented by the reciprocal of the proportion of internal incomes spent on imports. This doctrine asserts the very opposite of Say’s Law: the level of production will not be confined by the availability of capital and labour; on the contrary, the amount of capital accumulated, and the amount of labour effectively employed at any one time, will be the result of the growth of external demand over a long series of past periods, which permitted the capital accumulation to take place that was required to enable the amount of labour to be employed and the level of output to be reached which were (or could be) attained in the current period.

Keynes, writing in the middle of the Great Depression of the 1930s, focused his attention on the consequences of the failure to invest (due to unfavourable business expectations) in limiting industrial employment below industry’s attained capacity to provide such employment; and he attributed this failure to excessive saving (or an insufficient propensity to consume) relative to the opportunities for profitable investment. Hence his concentration on liquidity preference and the rate of interest, as the basic cause for the failure of Say’s Law to operate under conditions of low investment opportunities and/or excessive savings, and the importance he attached to the savings/investment multiplier as a short-period determinant of the level of production and employment.

On retrospect I believe it to have been unfortunate that the very success of Keynes’s ideas in connection with the savings/investment multiplier diverted attention from the ‘foreign trade multiplier’, which, over longer periods, is a far more important and basic factor in explaining the growth and rhythm of industrial development. For over longer periods Ricardo’s presumption that capitalists only save in order to invest, and that hence the proportion of profits saved would adapt to changes in the profitability of investment, seems to me more relevant; the limitation of effective demand due to oversaving is a short-run (or cyclical) phenomenon, whereas the rate of growth of’external’ demand is a more basic long-run determinant of both the rate of accumulation and the growth of output and employment in the ‘capitalist’ or ‘industrial’ sectors of the world economy.

– Nicholas Kaldor, Capitalism and industrial development: some lessons from Britain’s experience, Camb. J. Econ. (1977) 1 (2): 193204, link

Getting Paid To Have A Trade Deficit?


Source: BEA.

Eric Lonergan has written an interesting post about US trade deficits on his blog Philosphy Of Money/Sample Of One. In the post Eric claims that the United States is not a debtor of the world but that she is a creditor of the world! Eric also says that a lot of talk of all this is conventional wisdom and in reality the United States is getting paid to have lunch.

First, it’s no conventional wisdom. Most of standard macroeconomics is simply denying the importance of balance of payments. It is held that market mechanisms will correct imbalances, if only the government does its job. So there’s no conventional wisdom worrying about the trade deficit of the United States of America. It is exactly the opposite – a heterodox view.

Second, there is no “free lunch”. Imports put a drain on demand and output and because of the imbalance of the U.S. trade, full employment has been a distant dream. With so much of unemployment (especially in the crisis) and the slow recovery, one cannot claim that the U.S. has some free lunch. Only if there is full employment and that too remaining sustainable, can one claim that there’s some “free lunch”. A smaller point is that one needs the correct counter-factual: if the U.S. trade deficit had been lower, interest income (one of Eric’s main points) would have been even higher. So one more reason to avoid the phrase “free lunch”.

Moving to more important points. Eric claims that net return of FDI is high and hence BEA’s numbers are not right. Specifically he claims:

So here’s the crux: American generates a high positive net income from its net international asset position – which implies its net external asset position is a positive number. Despite running permanent current account deficits, the US has accumulated net external assets. this sounds less counterintuitive if you think that all it means is that US assets oversees are more valuable than foreign holdings of US assets.

To highlight how significant the difference is, BEA measures of US net external liabilities are around $7trn, if we simply value the net income on a PE multiple of 14x, the net external assets of the US are around $2.7trn!

An inconsistency this large seems extreme, but consider the valuation of foreign direct investment (FDI). According to the BEA, net FDI of the US has a value of less than $1trn, although the US earns $424bn on its overseas FDI and foreign FDI in the US only earns $153bn. If we value both income streams on 14x earnings, the US has net FDI assets of $4.2trn – the BEA ‘market value’ estimates are out by $3trn.

Now, that is not a correct way to approach this. To see the error, assume the stock of outward FDI is $100 and the stock of inward FDI is also $100 at market prices. Suppose investment receipts is $10 and income paid is $9. So it looks like the United States is earning $1 on a net FDI of 0. So according to this argument, the return is infinite!

It is better to look at the actual numbers:


Outward FDI: $6,695bn

Inward FDI: $6,196 bn.


Direct investment income: $776bn

Direct investment payments $592bn.

There is nothing drastically wrong about these numbers. Perhaps, it can be argued that direct investment in the US by foreigners will take time to pay off, or that foreigners are satisfied with this or something else. These numbers do not appear wrong.

Netting inward and outward and comparing returns to the net stock is an invalid argument, as I showed above with an example of inward/outward FDI of $100.

In addition, on Twitter Eric says a DCF (discounted cash flow) model also supports his thesis that the United States is a net creditor. The loophole in this argument is that it holds assets and liabilities vis-à-vis foreigners fixed. But because the United States runs current account deficits, liabilities rise faster than assets attributable to the deficit. So even if the U.S. earns interest income, net, from abroad, this effect will catch up.

There’s other way of saying all this. If is return on assets and are assets and liabilities.

rA > rL

rA ·A > rL·L

is not inconsistent with

A < L

Second, using subscripts, 0 and 1 for now and some point in future,

rA0 ·A0 > rL0·L0

does not imply automatically that

rA1 ·A1 > rL1·L1

because liabilities can rise faster than assets (because of current account deficits) and even if return on assets is higher than return earned by foreigners on U.S. liabilities, net interest income can turn negative.

Anyway, the point of this post is that while netting is a good concept, one cannot blindly net accounting numbers. The example, a net FDI of $0 earning a net income of $1 and hence infinite return(!) is not a valid way of doing accounting. BEA’s numbers look correct.

Last edited: 26 Mar 2016, 6:35 pm UTC

The ‘Paradox’ Of Protectionism

Paul Krugman says trade wars are a wash. Brad Delong is raising his neoliberal freak flag high.

Who is right? Answer: Neither. Global output will rise under non-selective protectionism (or has an expansionary bias, to be more precise). Protectionism reduces the propensity to import. That doesn’t mean imports will fall. Total imports of an individual nation will rise because of higher income. World trade will rise because of higher world income.

In other words, non-selective protectionism acts by reducing the propensity to import by price elasticity effects but raises volume of imports via income elasticity effects.

The world as a whole is balance-of-payments constrained, not just individual nations. Raising tariffs on imports incentivises producers to produce more as they will face less competition from abroad. Consumers will shift to domestically produced goods because of price elasticity effects.

Moreover, since governments of most nations won’t have a balance-of-payments constraint if there are large tariffs, they will be free to boost domestic demand by fiscal policy, limited only by the economy’s capacity to produce. If it is done, it will be a conscious behaviour by the government.

There is of course another way fiscal policy gets relaxed because of balance of payments. Reduction of current account deficits, relative to gdp, reduces the budget deficit, relative to gdp (as can be shown by a behavioural model and this shouldn’t be surprising as the two are related by an accounting identity). Typically governments follow some rules even if they aren’t explicitly required and their expenditure is endogenous to the government budget deficit: they tighten fiscal policy when the budget deficit goes out of a limit and relax fiscal policy when the budget deficit is within the limit. So improvement in a country’s balance of payments position would lead to a relaxation of fiscal policy, automatically.

To summarize, protectionism if done the right way can raise world trade because of rise in world income. There is no economic case against protectionism. There is opposition because few corporations want to increase their share in world markets. Protectionism reduces share of these mega corporations instead of reducing world trade. So “free trade” (which is managed trade for a few) only benefits a few and imposes a huge cost on the world economy.

All that is for the current world economic outlook. Typically in deep recessions governments take protectionist measures. In such scenarios, since output is falling, there is a tendency to confuse this with causation. It is more accurate to say that protectionism prevented a deeper implosion in such cases.

Non-selective Protectionism In Wynne Godley’s 1999 Article Seven Unsustainable Processes

‘Free Trade Loses Political Favour,’ says the front-page of today’s Wall Street Journal.

Free Trade Loses Political Favour

Paul Krugman has two articles conceding that he held wrong views earlier.

Krugman says:

But it’s also true that much of the elite defense of globalization is basically dishonest: false claims of inevitability, scare tactics (protectionism causes depressions!), vastly exaggerated claims for the benefits of trade liberalization and the costs of protection, hand-waving away the large distributional effects that are what standard models actually predict.

Krugman claims that he hasn’t done any of it but a reading of his 1996 article Ricardo’s Difficult Idea says the exact opposite.

The earliest cri de cœur of the U.S. balance of payments situation came from Wynne Godley in his 1999 article Seven Unsustainable Processes. 

In his sub-heading ‘Policy Considerations,’ he says:

Policy Considerations

The main conclusion of this paper is that if, as seems likely, the United States enters an era of stagnation in the first decade of the new millennium, it will become necessary both to relax the fiscal stance and to increase exports relative to imports. According to the models deployed, there is no great technical difficulty about carrying out such a program except that it will be difficult to get the timing right. For instance, it would be quite wrong to relax fiscal policy immediately, just as the credit boom reaches its peak. As stated in the introduction, this paper does not argue in favor of fiscal fine-tuning; its central contention is rather that the whole stance of fiscal policy is wrong in that it is much too restrictive to be consistent with full employment in the long run. A more formidable obstacle to the implementation of a wholesale relaxation of fiscal policy at any stage resides in the fact that this would run slap contrary to the powerfully entrenched, political culture of the present time.

The logic of this analysis is that, over the coming five to ten years, it will be necessary not only to bring about a substantial relaxation in the fiscal stance but also to ensure, by one means or another, that there is a structural improvement in the United States’s balance of payments. It is not legitimate to assume that the external deficit will at some stage automatically correct itself; too many countries in the past have found themselves trapped by exploding overseas indebtedness that had eventually to be corrected by force majeure for this to be tenable.

There are, in principle, four ways in which the net export demand can be increased: (1) by depreciating the currency, (2) by deflating the economy to the point at which imports are reduced to the level of exports, (3) by getting other countries to expand their economies by fiscal or other means, and (4) by adopting “Article 12 control” of imports, so called after Article 12 of the GATT (General Agreement on Tariffs and Trade), which was creatively adjusted when the World Trade Organization came into existence specifically to allow nondiscriminatory import controls to protect a country’s foreign exchange reserves. This list of remedies for the external deficit does not include protection as commonly understood, namely, the selective use of tariffs or other discriminatory measures to assist particular industries and firms that are suffering from relative decline. This kind of protectionism is not included because, apart from other fundamental objections, it would not do the trick. Of the four alternatives, we rule out the second–progressive deflation and resulting high unemployment–on moral grounds. Serious difficulties attend the adoption of any of the remaining three remedies, but none of them can be ruled out categorically.

[italics in original, underlying mine]

Bernie Sanders, U.S. Private Sector Deficits And Balance Of Payments

Over his blog The Beauty Contest – A blog on Spanish and international affairs, macroeconomics and finance, Javier López Bernardo has an analysis of Bernie Sanders’ economic plan (written with his colleague Rafael Wildauer).

Javier López Bernardo and  Rafael Wildauer stress the importance of the U.S. balance of payments constraint on U.S. growth. He uses a sectoral financial balances model to highlight how sectoral balances would look under Bernie Sanders’ plan: an exploding combination of U.S. private debt and negative net international investment position because of exploding negative financial balance of the private sector and the U.S. economy as a whole.

Also, they say:

We have not intended to bash Mr. Sanders’ economic program (actually, we are quite sympathetic with most of its measures) or Prof. Friedman’s economic exercise (which is useful to frame the economic discussion), but simply to highlight the incompleteness of economic analysis carried out in closed-economy frameworks – as the critics and Prof. Friedman’s exercise have exemplified.

Their projection is this chart:


Heterodox Blogger On Neochartalism

The trouble with Neochartalism (and called “Modern Monetary Theory” by the Neochartalists) is that what is correct is not original and what is original is not correct.

A popular heterodox blogger writing under the pen name “Lord Keynes” and blogging at Social Democracy For The 21st Century has written a post Limits Of MMT

It’s good to see the blogger point that the main trouble with Neochartalism is the balance of payments constraint. He/she has said this in the past in posts while promoting it, so it’s good to see a special post for this. I don’t agree with many things with “Lord Keynes” but given the blog’s popularity, I think it’s a good thing to have happened.

There is one thing I would have liked to see differently. It is sometimes said that Neochartalism works for advanced/rich nations and not for poor nations. But this gives too much importance to Neochartalism. This is because the rise and fall of nations itself depends on competitiveness in international markets. Saying “MMT works for advanced nations” makes it look as if the success and failure of nations is to be explained elsewhere. It’s still true of course that advanced nations can expand domestic demand by fiscal expansion but they also have to look after the being being of firms selling products in international markets, to stay competitive and not lose edge. Similarly as the blogger Lord Keynes says, “What is needed for much of the Third World is heterodox development economics, not MMT.”

More generally a concerted action is needed by world political leaders in which fiscal policies are coordinated with a set of consistent balance of payments targets.

Neochartalism has confused people more than they were confused earlier. It has to be debunked.

The World Balance Of Payments Constraint: Nicholas Kaldor Explaining The Way The World Works

Thirlwall’s Law is counter-intuitive and comes across as shocking. It says that the growth of a nation’s economy is directly proportional to the rate of exports and inversely related to the income elasticity of imports.

The reason it comes as shocking and difficult to believe is that our planet, with all inhabitants and institutions considered resident cannot export (unless there are non-residents such as aliens), but the world still grows.

Now there are several pitfalls in this argument. First, Thirlwall’s law doesn’t fail because the expression for growth rate is indeterminate. Rate of exports is indeterminate and the income elasticity of imports is indeterminate.

So we have

growth = inderminate/indeterminate

Second, the world does not have a central government. So the world as a whole is not comparable to a closed economy with a government.

There is a way in which the world as a whole is balance-of-payments constrained. The argument is by Nicholas Kaldor. In his 1980 article Foundations And Implications Of Free Trade Theory, written in Unemployment In Western Countries – Proceedings Of A Conference Held By The International Economics Association. At Bischenberg, France, Kaldor makes the argument for the world balance-of-payments constraint.

Nicholas Kaldor On Free Trade

Nicholas Kaldor on free trade

In a recent article on the ‘Causes of Growth and Recession in World Trade’,1 T. F. Cripps has demonstrated that a country is not ‘balance of payments constrained’ if its full employment imports, M*, are less that its import capacity M̅ (as determined by its earning from exports). Such a country is free to choose the level of domestic demand which it considers optimal for its own circumstances,2 whereas the other countries from whom M* > M̅, must, under conditions of free trade, reduce their output and employment below the full employment level, and import only what they can afford to finance. He then shows that the sum of imports of the ‘unconstrained’ countries determine the attainable level of production and employment of the ‘constrained’ countries, and the remedy for this situation requires measures that increase the level of ‘full-employment’ imports or else reduce the export share of the ‘unconstrained countries’. The ‘rules of the game’ which would be capable of securing growth and stability in international trade, and of restoring the production of the ‘constrained’ countries to full employment levels, may require discriminatory measure of import control, of the type envisaged in the famous ‘scarce currency clause’ of the Bretton Woods agreement.

In the absence of such measures all countries may suffer a slower rate of growth and a lower level of output and employment, and not only the group of countries whose economic activity is ‘balance-of-payments constrained’. This is because the ‘surplus’ countries’ own exports will be lower with the shrinkage of world trade, and they may not offset this (or not adequately) by domestic reflationary measures so that their imports will also be lower. Provided that the import regulations introduced relate to import propensities (i.e. to the relation of imports to domestic output) and not to the absolute level of imports as such, the very fact that such measures will raise the trade, production and employment of the ‘constrained’ countries will mean that the volume of exports and domestic income of the ‘unconstrained’ countries will also be greater, despite the downward change in their share of world exports.3


1Cambridge Economic Policy Review (March 1978), pp, 37-43.

2Owing to the widespread view according to which a given increase in effective demand is more ‘inflationary’ in its consequences if brought about by budgetary measure than if it is the result of additional investment or exports (irrespective of any limitations of import capacity) the inequality or potential inequality in its payments balance may cause a surplus country to regard a lower level of domestic demand as ‘optimal’ in the first case than in the second case.

3In other words, if countries whose ‘full employment’ balance of payments shows a surplus because M* < α W (where M* is the level of full employment imports, α is the share of a particular country’s exports of in world trade W) after a reduction of α to α̂ (α̂ < α) through the imposition of discriminatory measures, the country will still be better off if α̂ W* > α W where W* is the volume of world trade generated under full employment conditions.

[boldening mine]

What Kaldor is saying that because of balance of payments constraint of economies, the world as a whole has a slower growth because surplus nations do not expand domestic demand to the level needed. He is also saying that import controls raise imports rather than reduce them (this because of higher national income) and the exporters’ exports will also increase (even though their share is reducing.).

So the world as an built-in deflationary bias in the way it works.