Tag Archives: balance of payments

Sergio Cesaratto On TARGET2 Balances

Sergio Cesaratto has posted a reply on Matias Vernengo’s blog, replying to a paper by Marc Lavoie on economic problems of the Euro Area

For previous discussions, see the citations in that post or see my previous post on this.

Marc’s point is that because TARGET2 allows unlimited and uncollateralized credit/debit facilities between Euro Area NCBs and the ECB, the troubles facing the Euro Area are not balance-of-payments in origin.

As mentioned earlier, this however is not the thing to look at. One should look at counterparts to the intra-ESCB (TARGET2) debts. Intraday overdrafts, marginal lending facility, MRO, LTRO, ELA … none of these can rise without limit. At some point, a crisis occurs and foreigners’ help is needed.

Greece, Portugal, Ireland, Spain, Cyprus all have high negative net international investment positions. No wonder these nations have seen the most troubles.

I echo Sergio’s example (on Calabria) with a similar example of my own. If nations in a monetary union cannot face a balance-of-payments crisis, why not have the whole world join the Euro Area and adopt the Euro as their currency and have the ECB as the central bank of the world and guarantee all government debts without any condition? Surely, that should be the solution to the problems of the world! Not!

Surely austerity has been high and the ECB can help to keep government bond yields in check and allow for expansionary fiscal policies. It had its “OMT”, which has never been used as the annoucement effect itself has kept government bond yields low. But Greece has faced difficulties despite this.

The ECB alone cannot resolve the crisis.  Attempts to boost domestic demand with fiscal policy will bring higher imbalances within the Euro Area. The Euro Area needs a central government with high powers to tax and spend. Regional imbalances will be kept in check via fiscal transfers and regional policies of the government. And the powers of the government won’t be limited with this. There are many other things such as wages which need to be coordinated at the federal level, for example. Euro Area balance-of-payments cannot be neglected.

Sergio Cesaratto’s Debate With Marc Lavoie On Whether The Euro Area Crisis Is A Balance-Of-Payments Crisis – II

This is a continuation of the post from the end of 2014, although reading that isn’t necessary. 

In a new paper, Marc Lavoie continues his debate with Sergio Cesaratto on whether the Euro Area crisis is a balance-of-payments crisis or not. For the sake of completeness, here’s the list of papers, with references copy-pasted from Marc’s latest paper. Not all links are final versions and some may not be available to read in full).

  1. Cesaratto, S. 2013. “The Implications of TARGET2 in the European Balance of payments Crisis and Beyond.” European Journal of Economics and Economic Policy: Intervention 10, no. 3: 359–382. link
  2. Lavoie, M. 2015. “The Eurozone: Similarities to and Differences from Keynes’s Plan.” International Journal of Political Economy 44, no. 1 (Spring): 3–17. link
  3. Cesaratto, S. 2015. “Balance of Payments or Monetary Sovereignty?. In Search of the EMU’s Original Sin–Comments on Marc Lavoie’s The Eurozone: Similarities to and Differences from Keynes’s Plan.” International Journal of Political Economy 44, no. 2: 142–156. link
  4. Lavoie, M. 2015. “The Eurozone Crisis: A Balance-of-Payments Problem or a Crisis Due to a Flawed Monetary Design?” International Journal of Political Economy 44, no. 2: 157-160. (abstract)

As mentioned in my part 1, referred to on top of this post, I agree with Sergio Cesaratto.

sergio-and-marcSergio Cesaratto with Marc Lavoie (picture credit: Matias Vernengo)

Marc Lavoie’s main point in the final paper seems to be that, “Eurozone countries can never run out of TARGET2 balances, which can take unlimited negative values, so that the evolution of the balance of payments cannot be the source of the crisis”.

This is not accurate in my view. Although the rules of the Eurosystem allow unlimited and uncollateralized credit facility between the Euro Area NCBs and the ECB, one has to look at the counterpart to the T2 imbalances. If an economic unit transfers funds across border from country A to country B, this first results in a reduction of balances of banks in country A at their NCB and may result in an intraday overdraft (“daylight overdraft” in U.S. language), usage of the marginal lending facility with the NCB, an MRO, or an LTRO and finally ELA in late stages of a crisis (if capital outflow is large).

Marc himself mentions this point in his latest paper:

If a Eurozone country is running a current account deficit that banks from other Eurozone members decline to finance, or if it is subjected to capital outflows, then all that happens is that the national central bank of that country will be accumulating TARGET2 debit balances at the ECB. There is no legal limit to these debit balances. The national central bank with the debit balances, which pay interest at the target interest rate, has as a counterpart in its assets the advances that it must make to its national commercial banks at that same target interest rate. And the commercial banks can obtain central bank advances as long as they show proper collateral. Why would the size of current account deficits or TARGET2 debit balances worry speculators? There might be a problem with the quality of the loans that have been granted by the banks, or with the size of the government debt, but that as such has nothing directly to do with a balance-of-payments problem.

[italics: mine]

But that is the case! It’s because of balance-of-payments. Nations who had high indebtedness to the rest of the Euro Area saw more capital flight. This is because in times of crisis, there is a home bias and international investors are likely to sell securities abroad and repatriate funds home. Large current account imbalances lead to a large negative net international investment position. (It’s of course also true that revaluations are important, and this is what happened in the case of Ireland). So when non-residents sell securities to domestic investors, banks are likely to get into a bad situation because they have to accommodate these transfer of funds and are losing central bank balances on a large scale.

It is precisely nations which had worse net international investment positions which were affected as charted in my previous post on this.

Now moving on to definitions: what is a balance-of-payments problem? The simplest definition is the problem for residents in obtaining finance from non-residents. Greece precisely has been struggling to obtain funds from non-residents.

So I do not agree with Marc’s view that:

Cesaratto, as others, is adamant that the Eurozone crisis is a balance-of-payments crisis, whereas I believe, as others do, that this is a side issue.

Marc Lavoie also says that the people arguing for this view are implicitly assuming some kind of “excess saving” view on all this:

In discussions with colleagues who support a “current account deficit” view of the Eurozone crisis, I sometimes get the impression that they are also endorsing a kind of “excess saving” view of the economy. They tell me that current accounts deficits are unsustainable within the Eurozone because the core Eurozone countries will refuse to lend to the periphery and will thus prevent these countries from financing economic activity. This seems wrong to me.

I disagree with this. It’s precisely because residents’ liabilities are large compared to their financial assets that they have to rely on non-residents/foreigners. And during the crisis a lot of capital outflow has happened and this precisely shows that non-resident private investors are unwilling to lend again on the same scale as before. This obviously means that to obtain finance, governments of nations affected have to take the help of the official sector abroad, such as from governments, the ECB and the IMF. If TARGET2 alone could do the trick, is the Greek government foolish to go abroad?

It is of course true that the design of the Euro Area was faulty. But that still leaves open the question about why Germany is not facing a crisis as severe as Greece. The design view cannot explain this. Any country (or all countries) in the Euro Area could have faced a crisis. There is a pattern here and that is where balance-of-payments comes in.

This debate is an interesting one. Both Sergio Cesaratto and Marc Lavoie agree on almost everything, except this BIG thing.

Of course this also spills over to policy proposals. Marc Lavoie believes that the European Central Bank can guarantee that all nations can have independent fiscal policies (by promising to buy all government debt which the financial markets isn’t interested in purchasing). Sergio Cesaratto is clear on this (and I agree very much) – in another paper Alternative Interpretation of a Stateless Currency Crisis:

A more resolute role of the ECB as lender of last resort accompanied by fine-tuned expansionary fiscal policies can only be imagined in a different political and institutional framework, quite close to that of a political union.

Let’s consider what happens if there is no federal government and if the ECB is the main supranational authority (ignoring other supranational institutions which have limited powers). Suppose the ECB were to guarantee the debt of governments of all Euro Area nations. There’s nothing to prevent, say, the government of Finland to increase the compensation of its employees every year by a huge percentage and thereby affecting Finnish corporations’ compensation of its employees. This will result in a reduction of competitiveness of Finnish producers and Finnish resident economic units will rely more on goods and services produced abroad. This will raise Finland’s net indebtedness to the rest of the Euro Area and the world. If someone believes that this debt is not a problem, how about the inflationary impact of this rise in demand on the rest of the Euro Area?

So the solution lies in bringing down the balance-of-payments imbalances (both negative and positive ones such as that of Germany). This requires a supranational institution, which is a central government. National governments would have rules on their budgets but the central government — since its goals and objectives are different — wouldn’t be bound by any rules. Wage rises would need to be coordinated. And as I argue in this post, fiscal transfers also plays a role of keeping imbalances in check.

Of course there are many other economists who also argue that the Euro Area problem is a balance-of-payments problem, but with a different motive. Their argument is to blame the nations in crisis instead of taking a humanist approach.

To summarize, the Euro Area problem wouldn’t have been a balance-of-payments problem had the official sector promised to act as a lender of the last resort to national Euro Area governments without any condition. As long as there are conditions, it is a balance-of-payments problem. One cannot pretend that the European Central Bank has or can be given such powers to lend without any condition. And hence the Euro Area crisis is a balance-of-payments problem.

Economists Can Be So Wrong

Oh boy! Krugman could not have been more wrong about Macroeconomics than what he said recently in his blog The Conscience Of A Liberal for The New York Times. In a blog post, Competitiveness And Class Warfare, he concludes:

International competition is a mostly bogus notion; …

In a sense it is not surprising. Paul Krugman has done enough to push free trade. With that position, one is forced to take a position that competitiveness doesn’t matter (or that free trade will lead to a convergence between successful and unsuccessful nations).

The notion that balance of payments does not matter is as old as Monetarism. If it is understood that competitiveness does matter and that for a nation it hurts domestic producers and hence one needs some sort of protectionist measures goes against the notion of free trade. For neoclassical economists other than Paul Krugman, competitiveness does matter but in a different sense. They would argue that it there is divergence in performance of nations because of “loose fiscal policy” or “fiscal profligacy” and so on and that once the government balances its budget and behaves the way as per a standard textbook model, there’ll be convergence in performance because market mechanisms will do the trick. But Krugman is different. During the crisis, he has understood that fiscal policy is important and that it is not impotent as claimed by his colleagues.

There are of course other factors at play in the examples Krugman provides. Japanese producers are highly competitive but at the same time, the government of Japan didn’t expand domestic demand by fiscal expansion and so the performance of the economy of Japan has suffered. But that doesn’t mean that the competitiveness of Japanese producers doesn’t matter. Had they been less competitive, Japanese exports would have been lower than otherwise and Japan would have imported more because foreign producers would beat them at their home. Moreover, a weaker current account balance of payments would have led to a bigger government deficit and the Japanese government would have (incorrectly) tightened fiscal policy in response, with the result that both balance of payments and fiscal policy would have reduced domestic demand and hence output.

So while there are other factors affecting economic performance, none of it ever means that competitiveness doesn’t matter.

Cambridge economists were clear on this. Here’s Wynne Godley in a 1993 article Time, Increasing Returns And Institutions In Macroeconomics, in S. Biasco, A. Roncaglia and M. Salvati (eds.), Market and Institutions in Economic Development: Essays in Honour of Paolo Sylos Labini, (New York: St. Martins Press), page 79:

… In the long period it will be the success or failure of  corporations, with or without active help from governments, to compete in world markets which will govern the rise and fall of nations.

In trying to defend the importance of fiscal policy, some economists such as Paul Krugman become forceful in their views about the way the world works and underplay the importance of matters such as international competitiveness. They seem to falsely believe that this strategy would work for them because accepting the importance of competitiveness would give enough chance for their opponents to argue against worldwide fiscal expansion.  It is a sad and counterproductive strategy.

Federal Government And Regional Balance Of Payments

The Financial Times has a column titled Europe’s Fiscal Union Envy Is Misguided. The author echoes a recent article in The New York Times (referred here in my blog). According to the FT columnist, in the United States,

… The bulk of the risk-sharing happens through credit and capital markets – that is to say, private lending, borrowing and investment returns do most of the job of evening out regional shocks.


… The best thing the eurozone can do to promote risk-sharing is to stop flirting with its own disintegration: as long as investors suspect politicians might let the currency unravel, they will hunker down behind national borders. Next, get cracking on developing the capital markets union – where there is much more reason to envy the Americans.

In addition, the FT author presents the following graph.

FT Image 20 July 2015Now, there are several things wrong with this. It’s true that risk-sharing happens through credit and capital markets, the argument ignores that fiscal transfers improve the net indebtedness of regions. Financial markets may improve risks by the way they work, but they cannot change net indebtedness of regions in significant ways. Borrowing is not comparable to fiscal transfers. It’s vague what “capital income and insurance flows” is.

Let’s see how a federal system works.

There are regions with local governments but there is also a federal government which raises taxes from economic units of all regions and spends on the units. Some regions will be net recipients of such flows of funds — the government expenditure toward these regions is higher than what it receives in taxes — while others will pay more taxes than what they receive from the government. These needn’t sum to zero, as the federal government may be in a deficit.

There is one peculiar thing in the way such accounting is done. The federal government is outside all regions when studying balance of payments of each region. However for the whole group, the federal government is inside. The Sixth Edition of the IMF’s Balance Of Payments And International Investment Position Manual (BPM6) does this in a similar way for monetary unions, such as for the Euro Area. In that case, the European Central Bank and the European Parliament and other such supranational institutions are considered to be outside each nation when nations’ balance of payments statistics is produced, but inside when the balance of payments of the whole region is studied.

Now, some regions may see an improvement in their balance of payments compared to the case where there is no federal government. There are four kinds of flows which are important here when thinking about the current account balance of payments of a region:

  1. Exports
  2. Imports
  3. Federal government expenditures and transfers
  4. Federal taxes and transfers.

Of course, expenditure of the federal government in the region itself may be thought of as an export, so exports in the list above is meant to exclude that and include transactions such as a private sector producer selling a car to a household in another region.

So one can roughly identify surplus regions as ones which have higher exports than imports in the definition above and others as deficit regions. These transactions of course also affect the capital and financial accounts of the balance of payments and the “regional investment position”.

Usually, one thinks of “fiscal transfers” as affecting aggregate demand. But from the above analysis, it should be clear that it also affects the regional investment position. Economic units in deficit regions also see an improvement in their net asset position. Economic units in deficit regions in aggregate will typically receive more federal government payments than what they send in taxes. The counterpart to this in the capital and financial account of the balance of payments is an improvement in their net acquisition of financial assets and net incurrence of liabilities, as compared to the case where there is no federal government. This is turn improves the regional investment position.

Of course there is still a possibility that the private sector of a union with a federal government as a whole may turn unsustainable but at least there is a regional mechanism of improvement compared to the case when there is no federal government.

To summarize, the point of the above analysis is that the financial sector as a whole cannot achieve this on its own. It takes a federal government to not only affect demand in all regions but also keep their debts in check. The workings of finances of a federal government affects the asset and liability positions of any region as a whole. The financial sector cannot take up the task of a federal government.

Interest Rate, Growth And Debt Sustainability

Frequently, discussions about debt sustainability have discussions about the importance of the interest rate and growth in debt sustainability analysis. See for example, today’s Paul Krugman’s post on his blog. It is concluded that as long as the rate of interest is below the rate of growth, the ratio public debt/gdp doesn’t explode. Unfortunately, this result is erroneous.

John Maynard Keynes’ biggest disservice to the profession is to not start with the open economy. In my view, debt sustainability is tightly connected to balance of payments.

Imagine a nation whose exports is constant. If output rises, it will have adverse effects on the current account balance of payments because of income induced increase in imports. This will have an adverse effect on the international investment position of the nation: the net international investment position will keep deteriorating unless output is slowed down or some measure is taken to improve exports. In the case of rising exports, there is a similar constraint, except it is weaker but dependent on the rate of growth of exports.

If the ratio net international investment position/gdp keeps deteriorating, either the public debt to non-residents or private indebtedness to non-residents or both have to keep rising, all unsustainable.

There are some complications. A nation’s balance of payments also depends on how assets held abroad and liabilities to foreigners affect the primary income account of balance of payments. Also, the exchange rate can depreciate (or be devalued in fixed-exchange rate regimes) improving exports and reducing imports. However assuming that exchange rate movements do the trick is believing in the invisible hand. Foreign trade doesn’t just depend on price competitiveness but also on non-price competitiveness. These complications are highly interesting but do not affect the fundamental fact that a nation’s success is dependent on the success of corporations to compete in international markets for goods in services.

Even the conclusion that the government should contract fiscal policy and aim for a primary surplus in its budget balance or else the ratio public debt/gdp keeps rising if the rate of interest is greater than the rate of growth is erroneous. Consider a closed economy. An expansion in fiscal policy will automatically raise output and gdp and hence tax collections to prevent the ratio public debt/gdp from exploding. The public sector balance may hit primary surpluses but not due to contraction of fiscal policy or targeting a primary surplus in its budget balance.

In short, although the rate of interest and the rate of growth are important in debt sustainability analysis, it is not as easy as is usually presenting in macroeconomics textbooks and in the blogosphere. For a more detailed analysis see the reference below.


  1. Godley, W. and B. Rowthorn (1994) ‘Appendix: The Dynamics of Public Sector Deficits and Debt.’ In J. Michie and J. Grieve Smith (eds.), Unemployment in Europe (London: Academic Press), pp. 199–206

Updated 8 Apr 2015, 6:52 am UTC.

The U.S. Net International Investment Position At The End Of 2014 [Updated]

The U.S. Department of Commerce’s Bureau of Economic Analysis today released accounts for the United States’ international investment position. The U.S. is sometimes called the world’s biggest debtor and its net international investment position is now (at the end of 2014) minus $6.9 trillion.

Here’s the chart from the BEA’s website. U.S. Net International Investment Position 2014A few points. The importance of the U.S. balance of payments and international investment position is quite neglected in analysis of the crisis. The United States’ economy went into a crisis (and the rest of the world with it) because a huge rise in private indebtedness led to a fall in private expenditure relative to income when the burden of the debt started pinching. This caused a drop in economic activity and was saved partly due to automatic stabilizers of fiscal policy as tax payments fell due to a drop in economic activity and partly due to a relaxation of fiscal policy itself by the U.S. government and governments abroad. But the huge rise in the U.S. government debt meant that resolving the crisis by fiscal policy alone would have been difficult. This is because a huge fiscal expansion would have meant that the U.S. trade deficit would have risen much faster into an unsustainable path.

See Wynne Godley’s article The United States And Her Creditors: Can The Symbiosis Last? from 2005 here arguing such things.

Back to the international investment position. There are a lot of interesting things about it. Although the U.S. in a huge debtor to the rest of the world, the return on assets held by resident economic units of the United States earn more than paying on liabilities to nonresidents. So according to the BEA release U.S. International transactions 2014, investment income in the full year was about $813 billion while income payments was about $586 billion. (More complication arises from “secondary income”).BEA-2014-U.S.-International-Transactions

In addition, revaluations of assets and liabilities also affect the international investment position and revaluations of direct investment held abroad has acted in the United States’ favour.

Of course this cannot always be the case. Take a simple example: Suppose an economic unit’s assets is $100 and liabilities is $150 and suppose assets earn 8% every year and interest paid on liabilities is 5%. So even though the economic unit has a net indebtedness of $50, it is earning

$100 × 8% − $150 × 5% = $0.5

However, if liabilities rise to $160 and beyond the net return turns negative.

In a similar way, there is a tipping point, beyond which the net primary income of the current account of balance of payments turns negative. Because the United States has a negative current account balance and the deficit adds to the net indebtedness every year, at some point in the future, the international investment position may reach a tipping point.

All this sounds as if domestic demand and output are unrelated. This is of course not the case. Imports depend on domestic demand and exports depend on economic activity abroad. Hence the constraint on output at home because if output were to rise fast, the net indebtedness of the United States will also rise fast.

Of course the concept of a tipping point may itself be misleading. Indebtedness can keep rising even if net primary income turns negative without any trouble in financial markets because it all depends on how the financial markets see the problem. But it may be said that once a tipping point is reached, the debt will start to rise much faster than now. My article here hasn’t gone into any analysis here with numbers but I will leave it for another day.

Balance Of Payments Adjustments

Paul Krugman seems to have been thinking on issues related to open economy monetary macroeconomics these days! He has recently warned his readers to not confuse accounting identities with causation but in a recent blog post he seems to be doing it himself.

So Krugman says:

So, here we go. Start from the observation that the balance of payments always balances:

Capital account + Current account = 0

where the capital account is our sales of assets to foreigners minus our purchases of assets from foreigners, and the current account is our sales of goods and services (including the services of factors of production) minus our purchases of goods and services. So in the hypothetical case in which foreigners lose confidence and stop buying our assets, they’re pushing our capital account down; as a matter of accounting, then, our current account balance must rise.

But what’s the mechanism? (Remember the fallacy of immaculate causation.) The answer is, it depends on the currency regime.

Strange. The last statement in the quote warns of potential mistake which is present in the previous statement! ie Krugman wants to have it both ways.

So “… as a matter of accounting …” ?

Let us consider a case (fixed exchange rate or floating) where there is an autonomous capital flow – such as a foreigner liquidating a bond and repatriating funds. This by itself doesn’t affect the current account. In fact it can be compensated by some accommodative flow in the capital account of the balance of payments.

There is a nice 1991 article by the BIS Capital flows in the 1980s: a survey of major trends. The author quotes James Meade who makes this distinction between autonomous flows and accommodative flows:

[accommodative capital flows] take place only because the other items in the balance of payments are such as to leave a gap of this size to be filled … [while] autonomous payments … take place regardless of other items in the balance of payments.

Of course because of flexible exchange rates, the distinction can become blurred but the same is also true in fixed exchange rates. So we have an item called Other Investment in the capital account of balance of payments – like the example in the IMF’s BPM6 (note: “financial account” in the BPM6 terminology, capital account means a different thing):

Balance Of Payments Capital Account

In addition Reserve Assets is also one. Again this is somewhat of a simplification and it is possible for other items to accommodate.

“Other Investment” is typically banking sector flows but refer to BPM6 for the full definition. “Reserve Assets” is things such as sale or purchases of foreign currency by the central bank or any other official institution. Sometimes a category Exceptional Financing is used – such as government borrowing in foreign currency in exceptional circumstances or official financing transactions from the IMF.

So changes in some items in the capital account can be balanced by changes in some other account in the capital account and not the current account. Of course this doesn’t mean that there is no causality from the capital account to the current account and I will come to it in a moment but what Krugman says is silly.

Let’s take a few examples starting with the simplest – and you guessed it right – the Euro Area ;-)

Suppose there is a capital flow where a German financial firm liquidates Spanish government bonds and transfers funds back home.

As I have explained in posts long back, this will lead to a TARGET2 imbalance in which the Spanish NCB will have a rise in indebtedness to the ECB (which is considered to be a Spanish non-resident). Either it ends here or the Spanish banking system will try to attract funds from abroad. In either case there is an accommodative flow in the balance of payments – balancing the initial outflow and without affecting the current account.

Now take the example of a nation with its currency pegged to another anchor currency. Suppose a nonresident economic unit sells sells securities and transfers funds outside the country. Since banks acts as dealers in the foreign exchange markets, this leaves the banking system with a short position in foreign currency. It may try to close it by borrowing in foreign currency or try to attract funds from outside. In the latter case that is all there is to it (in the short term) and this flow is accommodating and will appear in Other Investment. In the former case, the banking system is left with an open position in foreign currency. As long as the bank’s own risk management or the central bank (with the confident knowledge that it has sufficient foreign exchange in case it has) thinks this it is alright, this is what there is for the short term. Else banks may need to attract funds from abroad. However if there is a depreciation outside the tolerable band (fixed doesn’t mean god has fixed it) in response to a huge amount of capital outflow, the central bank may sell foreign currency. It may also try to hike interest rates to get attract foreigners.

Again no change in the current account. One item in the capital account cancels another to preserve the accounting identity Krugman quotes.

In floating exchange regimes this is more complicated but the story is not too different from the BoP viewpoint. An outflow of funds will be accommodated by banks’ open position (or inventories). Banks will typically try to offload the inventories depending on market conditions and opportunities and it is sometimes said in the fx microstructure theory that the inventory half-life is around 15 minutes. The currency will depreciate to the point where expectations of the market participants reverse in the direction of appreciation bringing in flows in the opposite direction to the initial capital outflow. How this works precisely is a very challenging open question. Of course looked at from a medium term perspective, in general, it is not immediately obvious why the current account balance and capital account sum to zero since the magnitude of “Portfolio Investment” and “Direct Investment” may be quite different from the current account balance. But the sum of balances is zero as a matter of accounting. In such cases, banks may try to attract funds from abroad themselves by marketing bonds offshore – i.e., they may try to find offshore funding. More complications arise from derivative contracts with nonresidents which is not easy to go into in this post.

Of course this not guaranteed to work – pure float is the luxury of a few nations –  and sometimes the central bank may need to intervene in the foreign exchange markets and in the extremis, undertake exceptional financing transactions such as borrowing from the IMF.

In recent times, the Reserve Bank of India had an interesting swap scheme with the banking system who would attract funds from abroad.

Of course, none of this means there is no causality from the capital account to the current account. A nation may face troubles financing its balance of payments and it may try to deflate domestic demand by fiscal and monetary policy to keep its current account imbalance from getting out of hand. It is important to note here this is not a straightforward result of the identity but there is a more complicated story and that output suffers because of this. Krugman makes it sound as if nothing happens to output.

Balance Of Payments Crises

Phil Pilkington takes an issue with Sergio Cesaratto on the usage of the phrase “balance-of-payments crisis” on problems of the Euro Area.

Phil’s argument is that typically nations facing balance of payments problems need foreign currency and it manifests itself as a depreciation of the domestic currency but in the Euro Area this isn’t the case (because the exchange rates are fixed irrevocably between the Euro Area nations by the national central banks and the ECB). So the usage of the phrase “balance-of-payments crisis” is an abuse of language.

Now, to be short my argument that there is nothing wrong with the usage is because of the definition of what “balance-of-payments” actually is. Here is why:

A balance of payments transaction is a transaction between residents and non-residents. It is not relevant in which currency the transaction really is. So if you were a U.S. resident and if I as an Indian pay you $1 in New York in person, it is still a balance of payments transaction from the viewpoint of the United States. (of course if I own a firm in the United States which pays you then it is not a balance of payments transaction because the firm would be a resident).

In this way it becomes clear that some Euro Area nations have a balance of payments financing problem and since it reached a crisis level, the problem can be classified as a balance of payments crisis even though there is no exchange rate which has collapsed.

The nations which were/are in troubled had difficulties because they had huge current account deficits and as a result became indebted to the rest of the Euro Area. This became unsustainable and turned into a crisis. And both borrowers and lenders are to be blamed.

Since these nations had huge indebtedness to the rest of the Euro Area, they had troubles borrowing and refinancing their debts with foreigners and still have.

So I do not know why someone can take an issue with the phrase “balance-of-payments crisis”.

Except for the huge depreciation of the domestic currency, the Euro Area economic dynamics resembles a typical balance-of-payments crisis in all other ways. There is deflation of domestic demand, financial instability, high unemployment, increase in poverty and decrease in happiness and standard of living etc. There is international help in both cases.

Once again. A BoP transaction is between residents and non-residents. (See 2008 SNA, and BPM6 on this). A BoP crisis hence is a crisis in which borrowing and refinancing existing debt from non-residents has become difficult and is at crisis levels.  Whatever a country such as Portugal does at the moment, some units will be left indebted to the rest of the world/Euro Area. This is because liabilities are greater than financial assets and the difference is the net indebtedness to foreigners. Whatever new debts are created are equal in value to newly created financial assets. So the arithmetic dictates foreigners should be relied upon. The one qualification is that Portugal significantly improves its net exports but that is the same as saying its balance of payments is improving.

So anyone saying it is not a “balance-of-payments crisis” is fooling himself/herself.

Here’s Blaming The Rest Of The World For India’s Problems

Recently India is going through a mini-crisis where its currency has plummeted and with hosts of other reasons such as high inflation and a dysfunctional government not just because of the ruling party but also because of the opposition. In all this corruption has risen a lot. During the last few weeks, the Reserve Bank of India – the central bank – has tried to fight the depreciation of the rupee by taking various steps but in spite of this, the currency kept depreciating.

Unsurprisingly, a blame game has begun. To some extent it is good. It shows that the subject Economics isn’t what it has pretended to be – else we would never have had these debates. Simon Johnson recently wrote an article India’s Economic Crisis for NYT’s Economix which once again reminded economists of how dangerous the ideology that financial crisis are a thing of the past can be.

Initially some section of the media made it appear as if the Reserve Bank of India governor is blaming it on the “tapering” of the large scale asset purchases of the U.S. Federal Reserve. In fact an RBI release appeared to say it explicitly. But the RBI governor Duvvuri Subbarao has of course clarified saying that it was just a trigger but put the blame on India’s Finance Minister.

Economists seem to blame the Reserve Bank of India (and the supposed “fiscal indiscipline” of the government). According to them the RBI created a panic of sorts by reacting and this exacerbated the pressure on the Indian Rupee. So according to Swaminthan Aiyar, an economist who wrote an article titled India’s Problem Is Exports, Not the Rupee,

A falling rupee is a political, not an economic disaster

How silly can that get. While the title is okay (India needs more exports), but the above slogan just echoes the thought held among economists that the central bank shouldn’t interfere in the currency markets and that somehow the currency may have stabilized. Criticising the Reserve Bank is like criticising someone under attack for trying to defend (but failing to defend properly). It is important to realize that this “there is always a price” notion is an ideology of economists – a depreciation of a currency says something about it acceptability in international markets. So the fear is that the Rupee may become unacceptable in international markets and go to the IMF for help to refinance its international debts and the pound of flesh demanded in return. If the Rupee continues to depreciate, there will be further outflow of foreign funds and domestic banks will come under tremendous pressure in the foreign exchange markets in which they act as dealers. Perhaps Aiyar needs some lessons from Simon Johnson.

Paul Krugman suggests that India’s net international investment position hasn’t deteriorated and wonders what the issue really is. While it is true that India’s NIIP is not as worse as countries such as Hungary, there is no hard and fast rule that minus 20% is good and minus 100% is bad. India’s currency doesn’t have a brand and acceptability in international markets and 20% can be bad considering the direction in which it is headed given the current account deficits.

The silliest thing I heard (saw actually in a Tweet) is: Japan’s currency is depreciating and that is not a crisis but India’s currency is depreciating and that is a crisis – isn’t that self-contradictory? No it isn’t. Japan is a net creditor to the rest of the world and can talk up its currency as fast as it talked down its Yen. Japan is in a position where it instead can boost domestic demand instead of beggaring its neighbours.

There are other blame games as well. There has been a sharp rise in corruption – or perhaps it is more right to say that such cases have come to the limelight while it has always existing at a large scale. So this has caused India’s troubles. Although there is truth to it, this by itself doesn’t cure India’s external problems. Imagine if these problems hadn’t existed and that there was a rapid rise in output (which anyway is not bad compared to the rest of the world). The rise in output would come about with a rise in domestic demand and this would have also led to a rise in imports deteriorating the balance of payments.

One frequent slogan when such troubles arise in the external sector – and which has been repeated recently – is “increase productivity”. While increase in productivity is welcome (so long as it accompanies a rise in production), this is separate from relative competitiveness with the rest of the world. It is true that a rise in productivity can have some effects on competitiveness but the causality is quite different from what economists generally assume. The major cause of rise in productivity is the rise in production itself and if a nation faces a balance of payments constraint, its production is affected because of deflationary means need to be adopted to keep imports in check.

During the financial and economic crisis which began around 2007, India was the among the first nations to boost domestic demand by fiscal policy. India was already a Keynesian when the phrase “we are all Keynesians” became popular. India has done the opposite of the beggar-my-neighbour policies but has run out of steam and it is time the world boosts domestic demand and ease the constraint on the few “emerging markets” in the news.

It is a deep bias in the economics profession that balance of payments imbalances have a self-adjusting market mechanism. In the years of the Bretton-Wood it was thought that the Mundell-Fleming fixed exchange rate models explained how imbalances would self-correct. But this proved to be wrong. After the fall of the Bretton-Woods, when exchange rates floated, it was thought that there is a market mechanism via prices changes (exchange rate) to keep imbalances in check but – with exceptions of a few – economists again failed to notice their bias with their focus being shifted by Milton Friedman’s Monetarism who also hand-waved the “market mechanism” in order to promote free trade. India’s troubles is another reminder of how their intuitions are wrong. Instead of changing it, they simply blame the government.

It is time for the rest of the world to first boost domestic demand so that India’s exports rise to pay for its imports. This is beneficial to the world itself because it will enjoy more imports. Some criticisms of the Indian government are true but this alone is far from sufficient in solving India’s problems. More importantly, there is no market mechanism to resolve imbalances – a drastic change in coordination of fiscal and monetary policies combined with trade policies which are mutually consistent and beneficial are required.

Manmohan Violet Singh

In a short recent speech, the Indian Prime Minister – the great man who steered the direction of the Indian economy in the early 1990s – says:

The purpose of the study of economics is not to provide settled answers to unsettled and difficult questions, but sometimes to warn economists and the world-at-large, how not to be misled by clever governments.

which is similar to what Joan Robinson once:

The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.

– in “Marx, Marshall And Keynes”Occasional Paper No. 9, The Delhi School of Economics, University Of Delhi, Delhi, 1955.

I’d say Manmohan Singh doesn’t go as far as Robinson in putting the blame on economists themselves but I guess there is some amount of influence. But what Singh says is true – governments of advanced nations mislead the less advanced ones.

Also in the short speech:

I would like to say, that when we study economics, our impulse is not the philosopher’s impulse – knowledge for the sake of knowledge – but for healing that that knowledge may help to bring. These are the words of past thinkers: Wonder is the beginning of philosophy; but it is not wonder, but social enthusiasm, which revolts against the silence of fixed life, and the orderliness of the mainstream, which is the beginning of economic science.

Which is not not surprising since Manmohan Singh is influenced by Joan Robinson and Nicholas Kaldor. Here is a nice interview by the BBC’s Mark Tully from 2005 Architect Of The New India published in the October 2005 issue of the Cambridge University Alumnus Magazine. 

Here is an excerpt from the interview:

The thinking behind his solutions to India’s financial problems was first shaped at Cambridge by the theories of John Maynard Keynes. The great man had died almost 10 years before Manmohan Singh arrived but his legacy was still very much alive. ‘At university I first became conscious of the creative role of politics in shaping human affairs, and I owe that mostly to my teachers, Joan Robinson and Nicholas Kaldor. Joan Robinson was a brilliant teacher but she also sought to awaken the inner conscience of her students in a manner that very few others were able to achieve. She questioned me a great deal, and made me think the unthinkable. She propounded the leftwing interpretation of Keynes, maintaining that the state has to play more of a role if you really want to combine development and social equity.’

‘Kaldor influenced me even more; I found him pragmatic, scintillating, stimulating. Joan Robinson was a great admirer of what was going on in China, but Kaldor used the Keynesian analysis to demonstrate that capitalism could be made to work. So I was exposed to two alternative schools of thought. I was very close to both teachers, so the clash of thinking sometimes got me into difficulties. But that made me think independently.’

In Other News

The Reserve Bank of India announced some measures recently to curb the instability of the Indian Rupee:

The first announcement – effectively raising short term interest rates and which caught everyone by surprise – was on 15 July 2013:

The market perception of likely tapering of US Quantitative Easing has triggered outflows of portfolio investment, particularly from the debt segment. Consequently, the Rupee has depreciated markedly in the last six weeks. Countries with large current account deficits, such as India, have been particularly affected despite their relatively promising economic fundamentals. The exchange rate pressure also evidences that the demand for foreign currency has increased vis-a-vis that of the Rupee in part because of the improving domestic liquidity situation.

Against this backdrop, and the need to restore stability to the foreign exchange market, the following measures are announced:

On 23 July it further tightened monetary policy:

Over the last two months, the Reserve Bank of India (RBI) has undertaken several measures to contain the volatility in the foreign exchange market. Among them, some measures intended to check excessive speculation adding to undue volatility in market conditions were instituted vide the RBI’s Press Release No.2013-2014/100 dated July 15, 2013. These measures have had a restraining effect on volatility with a concomitant stabilising effect on the exchange rate. Based on a review of the measures, and an assessment of the liquidity and overall market conditions going forward, it has been decided to modify the liquidity tightening measures as follows: