Tag Archives: international investment position

Abraham Ptachya Lerner, An Inconsistent Fellow

This quote of Abba Lerner from his article “The Burden of the National Debt,” in Lloyd A. Metzler et al.,Income, Employment and Public Policy (New York, 1948), p. 256 is frequently quoted in the Post-Keynesian blogosphere:

One of the most effective ways of clearing up this most serious of all semantic confusions is to point out that private debt differs from national debt in being external. It is owed by one person to others. That is what makes it burdensome. Because it is interpersonal the proper analogy is not to national debt but to international debt…. There is no external creditor. “We owe it to ourselves.”

This is unfortunately inconsistent with his “functional finance”. Abba Lerner clearly says that external debt can be problematic. However he probably never realized that if his advise is followed in running fiscal policy, a nation’s balance of payments will deteriorate and its international debt will increase (because current account balance adds to the net international investment position).

Public debt is not the same the negative of the net international investment position but it’s related as the external debt is directly or indirectly picked up by the public sector.

Sound finance is all junk science but Abba Lerner is not your friend to learn about money, debts, deficits and all that.

Getting Paid To Have A Trade Deficit?

intinv315-chart-01

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:

Stocks

Outward FDI: $6,695bn

Inward FDI: $6,196 bn.

Flows

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

Limits To Growth, Part 3

[For previous discussions, see my posts Limits To Growth? and The Full Employment Assumption]

Brian Romanchuk has written a post as a response to my post Limits To Growth? referred above. In that his tone seems to be that the U.S. does not face an external constraint fundamentally, and that trade acts as a drag only because politicians have an impression that there exists a constraint.

To hold that claim Brian should to able to defend the dynamics which is likely if that were the case: the U.S. public debt and the net international investment positions deteriorate without limit (relative to gdp). Not sure at the moment if he thinks that debt/gdp ratios can grow without any limit.

That is the financial aspect of his argument. From the trade perspective, Brian says:

In any event, the U.S. could get away with strong GDP growth without causing external difficulties right now. There is plenty of spare global manufacturing capacity, so rapid U.S. growth would be accommodated by exporters. After awhile, there would be a self-reinforcing global growth spurt, which will reduce the pressure on the U.S. trade balance.

There are two things. One is capacity constraint and the other competitiveness.  Both I and Brian agree there is no need to worry about the former. (Unlike neoclassical economists who are worried about the former!). It is about the latter where the debate is. This is in addition to the financial aspect mentioned in the previous paragraph.

The U.S. having plenty of spare manufacturing capacity has little impact on competitiveness. At a micro level, one can think of a firm with lots of idle resources but the sales team not being able to win projects for the firm. So two things—capacity and competitiveness—need to be studied separately. If the rest of the world does not expand, there is not much U.S. firms can do. If they produce more stuff, it will just be left as additional inventories forcing a clearing sale in domestic markets at the year end. So presence of spare capacity cannot make U.S. exports grow if domestic demand rises, either due to rise in private expenditure or via fiscal policy. In addition, there’s no self-reinforcing global growth because exports won’t take off to begin with.

To be more technical, there is one way in which U.S. exports may rise. If production rises, then via the Kaldor-Verdoorn process, U.S. productivity will also rise and this affects pricing of products and U.S. exporters may get some price advantage.

So rise in production can lead to a rise in competitiveness.

But this effect is quite negligible in the short run because competitiveness is both about non-price competitiveness and price competitiveness. 

There is an additional effect. U.S. production rising means rise in national income and rise in imports. This implies a rise in global output and demand and helping U.S. exports. Again, this effect is small and doesn’t prevent a deterioration of balance of payments and international investment position. So U.S. production rising helps exporters a bit but not much.

What the world needs is a coordinated policy to raise output by fiscal policy and putting limits on balance of payments imbalances.

Whoever becomes President of the United States has to not only take care of domestic policies but also act as a leader in world wide policy.

All this is about the future. But it’s not that the U.S. balance of payments hasn’t mattered in the past. Because of imbalances in trade, the U.S. fiscal policy could not save the U.S. i.e., could not bring the economy back into full employment quickly. It has taken about 9 years and there is still not full employment. So much has been lost. The critical imbalance in U.S. trade is the numero uno reason for the lack of a quick recovery. It could be said that the U.S. could have expanded fiscal policy and that is quite true but it would have put the U.S. debts on unsustainable path.

Digression

It is sometimes said, such as by a commenter in Brian’s blog that “balances balance”, so there is no need to worry about them. There is no imbalance as per an economist. This is a dubious argument. Surely the private sector can be in deficit for long and it is matched by items in the financial account of the system of national accounts. But surely private sector deficits for long is unsustainable as agreed by everyone around here. So “balances balance” is no argument.

United States’ Net Wealth

The latest release of the Federal Reserve Statistical Release Z.1, Financial Accounts of the United States – Flow of Funds, Balance Sheets and Integrated Macroeconomic Accounts or just “flow of funds” has a new table B.1: Derivation of U.S. Net Wealth.

According to the release:

A new table on the derivation of U.S. net wealth (table B.1) has been added to the summary section of the “Financial Accounts.” The calculation of U.S. net wealth includes the value of nonfinancial assets (real estate, equipment, intellectual property products, consumer durables, and inventories) held by households and nonprofit organizations and noncorporate businesses. For the federal government and state and local governments sectors, only structures, equipment, and intellectual property products are included; values for land and nonproduced nonfinancial assets are not available. The measure of U.S. net wealth also includes the market value of domestic nonfinancial and financial corporations, and is adjusted to reflect net U.S. financial claims on the rest of the world. This definition of U.S. net wealth differs from the sum of the net worth of sectors shown in the Integrated Macroeconomic Accounts (IMA). A forthcoming FEDS Note will provide additional information.

United States Net Worth

click to expand, and click again to zoom

According to it, the United States net wealth was $79.69 trillion.

It’s important to understand how this is reached. Normally we divide the world in various sectors: households, production firms, the financial sector, government and the rest of the world. In real life one adds more nuances to all this. So for example, in the table above, we have a sector “non-financial non-corporate businesses”.

Now, there are two types of assets: non-financial assets and financial assets. Non-financial assets are things such as houses, machines and so on. Financial assets are things such as currency notes, bonds, equity securities and so on.

In the system of national accounts (e.g., the 2008 SNA), all financial assets have a counterpart liability. So financial assets = liabilities for the world as a whole. It’s of course not true for a nation because assets and liabilities between residents and non-residents do not cancel out.

There is one complication, however: equity securities. The 2008 SNA treats equity securities as liabilities of corporations, just like debt securities. This is despite the fact that a company isn’t bound by law to pay dividends to holders of equity, unlike the case for debt securities or loans (for which interest is needed to be paid periodically and also the principal upon maturity).

All economic units have a net worth. This is the difference between assets and liabilities. So,

Assets = Liabilities + Net Worth.

Since equities are treated as liabilities in the 2008 SNA, the net worth of firms can in fact turn negative. This might happen if the price of equities is high.

So it is easy to derive the net worth of a nation. Resident economic units’ liabilities held by resident economic units cancel out and one is left with non-resident units’ liabilities to residents (i.e., resident units’ assets “held abroad”) and residents’ liabilities to non-residents.  This is the net international investment position.

So, as per the 2008 SNA (and the Balance of Payments Manual, 6th Edition),

Net Worth of a nation = Non-financial assets held by residents + Net International Investment Position

The Federal Reserve however does not do the same for flow of funds. It does not treat equities as liabilities.

But one has to be careful about double counting. It’s easy to sum up non-financial assets of all economic units, such as as done by the SNA. But in the flow of funds, with the special treatment on equities, we shouldn’t use corporate businesses’ non-financial assets. If you read the explanation and see the table B.1 carefully, corporate businesses’ assets have not been added, only “non-corporate businesses'” non-financial assets have been added. Since equities are not treated as liabilities in the sense of debt securities, the market value of corporations is needed to be added. This is line 13 in Table B.1.

There is one complication however. Even though equities is not treated as liabilities, that held by foreigners is treated as liabilities. Otherwise, one can have a source of inconsistency. Suppose equities held by a non-resident economic units is not treated as liabilities. Suppose foreigners sell $1bn of equities and purchase T-bills with that. This will mean that the net wealth reduces. Which doesn’t make sense. Hence, one is forced to treat foreigners’ equity holdings as liabilities. So the foreign aspect of the whole calculation is the same as as done in the SNA and one needs to include the net international investment position of the United States which is line 24. (minus $5.47 trillion).

So that basically summarizes the calculation of the United States net wealth as per the Federal Reserve flow of funds report.

How does this compare with the SNA measurement? Some tables in the report are only updated to 2014. So let’s use those numbers.

Flow of funds’ net wealth for 2014 = $77.89 tn (Table B.1, line 1).

Now, go to Table S.2.a. These tables use SNA definitions. Add lines 76-81.

This gives us a value of $87.34 trillion.

However the Z.1 report has an error in the way SNA/IMA way of calculating net worth. Line 77 in Table S.2.a is incorrect. There’s double counting. It uses the SNA/IMA concept of net worth but instead calculates it using the FoF concept. One should subtract line 29 in table B.101 which is $10.04 trillion. Hence the US net worth in the SNA definition is $87.34 trillion minus $10.04 trillion which is $77.30 trillion.

So in short, the net worth of the United States as per the flow of funds definition at the end of 2014 was $77.89 trillion and according to the SNA/IMA it was $77.30 trillion.

What does all this mean? Hmm. Not to easy to answer, except saying that familiarity with the system of measurement helps in understanding how the economy works. Which measurement is better – the new table B.1 or S.2.a? Doesn’t matter.

I am thankful to commenters in this blog post by Steve Randy Waldman, especially JKH and Marko.

Last edited 8 Oct 2015, 2:22pm UTC. [Error in Fed’s Z.1 report pointed out and my own fixed]

Update: Part 2 of this post/afterthought here United States’ Net Wealth, Part 2

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.

Reference

  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.

Cyprus Rescue

Cyprus has recently received the attention of academicians and financial professionals in recent weeks. Need I say that?

So national bankruptcy is to be resolved by winding down a bank, moving guaranteed deposits (i.e., upto €100,000) to another and as per the latest Reuters article on this, big numbers (anywhere ranging from 20 to 40 per cent loss on deposits on amounts over €100,000) are quoted.

Martin Wolf has a good summary:

The current plan is closer to what one would wish to see in an orderly bank resolution. Laiki Bank is to be split into good and bad banks. Deposits of less than €100,000 in the bank and assets worth €9bn – the sum owed to the central bank as part of its liquidity support – will be transferred to Bank of Cyprus. The remainder will be wound down. Those with claims to deposits in excess of €100,000 will obtain whatever the value of the bad bank’s assets turns out to be.

Meanwhile, savers at the Bank of Cyprus with deposits of more than €100,000 will have their accounts frozen and suffer a “haircut” of still unknown size. That reduction in value is likely to be large: perhaps 40 per cent. Finally, temporary exchange controls are to be imposed.

Why are the reasons for such huge numbers?

The reason is that the nation has accumulated huge net indebtedness to foreigners over years and this has been financed by banks raising deposits from foreigners, so that if debt traps are to be avoided, foreigners are to be required to take losses.

The following is the international investment position of Cyprus at the end of Q3 2012 (source: Central Bank of Cyprus)

Cyprus - International Investment Position Q3 2012In the balance of payments literature, banks’ position is referred as Other Investment. Also, the above refers to a Financial Account but it really means net IIP. Ideally it would have been better if this data had been updated but the above information is useful nonetheless.

As a percent of gdp, the net IIP position (with the opposite convention to standard usage) was 81.1% (Source: Eurostat) which is big in itself but very much lower than the now famous banks’ liabilities to foreigners/Russians! (the second red box above).

If a nation wants to resolve bankruptcy, it is better to do it by imposing losses on foreigners – especially if an international lender of last resort is available! And if this is to done it in the optimal way, best to do it once – rather than keep doing it. The ratio of two red boxes in the table – i.e., net liability as a proportion of gross bank liabilities to foreigners is 24.56%.

So Cyprus needs to wipe out about this amount as a percent of deposits roughly. It is not necessary to reach a position of zero indebtedness but something low such as 10% of gdp is ideal. Some buffer is needed because there will be leakages in spite of capital controls – requiring fire sale of foreign assets (and subsequent losses) by banks or borrowing from the ECB which may want to ensure that banks have good collateral for the ELA. Foreign deposits below €100,000 shouldn’t be hit. So “net-net”, as a percentage, this may be higher than 24.56%. All this depends on the latest situation and the distribution of foreign deposits and also the distribution between residents and foreigners but 24.56% of deposits is a good starting point – it gives a rough estimate of the order of magnitude of the problem.

At any rate, losses imposed on foreigners have to be big for the ECB and Euro Area governments to stand behind.

Not A Balance-Of-Payments Crisis?

Here’s a new piece by Randall Wray on Economonitor claiming current accounts do not matter (once again!) and didn’t have much of a role on the Euro Area crisis. Part of his arguments are the same as those who participated in public debates 1991 (most, not all) and claimed the balance-of-payments doesn’t matter.

Perhaps he should revise his study of sectoral balances.

Before I consider his analysis, let me remind you why current account deficits matter. A current account deficit is the deficit between the income and expenditure of all resident units of an economy and because it is a deficit, it needs to be financed. Cumulative current account deficits lead to a rise in the net indebtedness of a nation (i.e., consolidated net debt of all resident sectors of an economy) and cannot keep rising forever relative to output. This is because a deficit in the current account is equal to the net borrowing of the nation which has to be financed and secondly, the debt built up needs to be refinanced again and again.

Here’s via Eurostat

It is clear from the chart that nations with high negative NIIP (and hence high net indebtedness) were/are the ones in trouble.

The accounting identity which connects the NIIP to CAB is:

Δ NIIP = CAB + Revaluations

Most of the times, revaluations have less of a role in explaining the NIIP. Of course one can always come up with exceptions – such as for the United States with huge revaluations due to outward FDI and Ireland. It should however be noted that Ireland also had high current account deficits.

Here is data from the IMF on the current account balances:

From this you can see “Germany is not Greece”, “Netherlands is not Spain”, “Finland is not Cyprus” and so on and also the relation of CAB to NIIP.

Let me turn now to what Wray has to say:

Yesterday one presenter at this conference provided a lot of interesting data on cross border lending by European banks, most of which consisted of lending to fellow EMU members. He showed a strong correlation between cross border lending and cross border trade. Hence, posited a link between flows of finance and flows of goods and services. So far, so good. He also accepted a comment from the audience that correlation doesn’t prove causation, and that flows of finance are orders of magnitude larger than trade in goods and services—in other words, most of the financial churning has nothing to do with “real” production.

So atleast Wray accepts there is a correlation of some kind. For causation, see the arguments presented at the beginning of this post.

I won’t rehash that argument. Balances do balance, after all. For every current account deficit there’s a capital account surplus. It seems to me that the claim that the EMU suffers from “imbalances” is on even shakier ground. After all, they all use the same currency, so there’s no chance that an “imbalance” will lead to a run on the currency and to exchange rate depreciation (a usual fear following on from a current account deficit).

This argument was made by neoclassical economists around late 80s and early 90s when Europe was planning to form a monetary union. See this post Martin Wolf Pays A Generous Tribute To Anthony Thirlwall. Wray misses the point that a balance-of-payments crisis also leads to a deflationary spiral and that even though there is no exchange rate collapse, there is deflation in the Euro Area – exactly as predicted by those economists who thought the notion “current account deficits do not matter” was precisely wrong in the early 1990s.

Then Wray goes on to suggest that banks creating a boom and bust in Germany would have looked different:

Yes. But in what sense is that an “imbalance”? Look at it this way. What if instead of running up real estate prices in the sunny south—so that Brits and northern Europeans could enjoy vacation homes—the German banks had instead fueled a real estate bubble in Berlin? What if they had eliminated all underwriting standards and lent until the cows come home on the prospect that Berlin house prices would rise at an accelerating pace? Speculators from across the world would buy a piece of the bubble on the prospect that they’d reap the gains and sell-out at the peak. Construction activity would boom, workers could demand higher wages and would increase consumption, and Germany would have experienced higher price inflation than the rest of Euroland.

In the hypothetical case of Wray where German banks lend the non-financial sectors till the “cows come home”, domestic demand would have risen sharply (which he himself suggests) and this would have had the adverse effect on the balance of payments. Germany would have started running current account deficits because imports are dependent on domestic demand. Germany would have suffered similar fate but in the end it would have depended on how fast the domestic demand rose.

Wray should be careful in doing sectoral balances.

Bad bank behavior can boom or bust an economy—with or without current account deficits. And that’s pretty much what happened in Spain and Ireland (and also in Iceland).

Wray would have sounded right if he had given examples of nations having current account surpluses but from IMF’s table above it can be seen that both Spain and Ireland had huge current account deficits.

What about Iceland?

The data is from 2004-2011 and you can see that in 2008, Iceland had a current account deficit of 28.4%.

Wray then compares the Euro Area to the United States:

In Euroland, all use the same euro currency, and clearing is accomplished among the central banks and through the ECB (that is where Target 2 comes in). It works about as smoothly as the US system. But here’s the difference: the ECB “district banks” are national central banks. It is thus easier to keep mental tabs on the “imbalances” by member states in the EMU than in the USA.

Yes keeping mental tabs on imbalances (and not “imbalances”) can have its effect, but Wray crucially misses the point that in the United States, there is an automatic mechanism of compensating for trade imbalances via fiscal transfers. This acts via lower total taxes paid by regions facing slowdown caused by trade imbalances (not to be confused with lesser taxes paid due to reduced tax rates if any). A rise in public expenditure (not necessarily discretionary but resulting from government guarantees made beforehand) also helps.

Wray however quotes Mosler but he misses the point as well since it talks of directed government spending as opposed to a built in automatic mechanism which (the latter) prevents a crisis at this scale/type from happening.

Generally speaking, Wray seems to suggest that the crisis happened because the private sector credit-led boom went bust and this has nothing to do with current account imbalances. While it is true that the private sector credit-led boom ended in a bust and caused a crisis, what Wray misses is that the current account deficits contributed to exacerbating the crisis because nations in trouble built up huge indebtedness to the rest of the world and had troubles to refinance their debts. If all sectors of an economy have a consolidated net indebtedness position to the rest of the world, they will have issues borrowing and refinancing since – as a matter of accounting – foreigners have to attracted. Foreigners were unwilling because of doubts and also because there was/is a crisis in the world economy, they changed their portfolio preferences – making the whole issue of financing even more difficult.

A Digression On TARGET2

It can be argued that since the TARGET2 mechanism has a stabilizer of some sort – that since the Eurosystem TARGET2 claims arising due to capital flight from the “periphery” is an accommodative item in the balance-of-payments, current account deficits shouldn’t have been an issue.

The error in this argument is that while it is true that capital flight is automatically financed by the resultant Eurosystem TARGET2 claims and that this is helpful, it depends on the hidden assumption that banks have unlimited/uncollaterilized overdrafts at their home central banks. We have seen in various scenarios – such as with procedures such as the Emergency Liquidity Assistance (ELA) – that banks in the “periphery” can either run out of sufficient collateral needed to borrow from their home NCB or have chances to run out of collateral. They hence need to attract funds from abroad. The nation as a whole is dependent on foreigners. Current account deficits are not self-financing.

U.S. Net Indebtedness Above $5T Now

The BEA reported yesterday that the U.S. Net International Investment Position at the end of 2011 was minus $4,030.3bn. The large change compared to the end of 2010 (where it was -$2,473.6bn) was due to large revaluations of assets and liabilities in addition to the current account deficit. See the BEA blog on this.

For IIP, Foreign Direct Investments are measured at “current costs”. When evaluated at market prices, the net international investment position at the end of 2011 would have been minus $4,812.4bn. The NIIP also includes official gold holdings and if this is excluded, the net indebtedness is greater than $5T.

The following is the NIIP as a percent of GDP at market prices.

There are several reasons this by itself hasn’t worked against the U.S. The U.S. dollar is the reserve currency of the world* and secondly direct investments make huge returns for the U.S. (It should still be noted that the current account deficits bleed demand in the U.S. at a massive scale). Direct investment abroad at the end of 2011 was about $4.5tn and foreign direct investment by nonresidents in the United States $3.5T.

U.S. International Investment Position

(click to enlarge)

The direct investment abroad makes a huge killing for the U.S. as can be seen from the balance of payments. In 2011, direct investment receipts was around $480bn and direct investment payments only $159bn.

U.S. Current Balance of Payments

(click to enlarge)

 *non-direct investment income is already against the United States’ favour though.

Downplaying TARGET2 Imbalances

Beate Reszat has written a very nice article on TARGET2 Target2 – Q&A which should be read by anyone interested. The article seems to be in response to a speech by George Soros earlier this month in Italy. The link appears in her post and the relevant section of the transcript quoted.

Although it is a very informative article, I think the writer gives a misleading picture by disagreeing with George Soros.

For a background, the whole debate started when a German Professor Hans-Werner Sinn wrote an article The ECB’s Stealth Bailout which led to a series of attacks from academicians to bankers to central banks seriously questioning Sinn. Sinn’s arguments are full of errors but this brought into focus the TARGET2 claims of creditor nations’ NCBs and the risks that this asset may “disappear”.

Critics of Sinn learned the TARGET system and to my surprise, their description had a lot of features on money endogeneity – surprising since most of these writers err on describing one pole (of the two poles) of money endogeneity – that between banks and their central bank.

In the end, the critics claimed victory – although powerful persons such as George Soros and Jen Weidmann of Bundesbank understood and saw the situation slightly differently. Even Martin Wolf who has differences with Weidmann on the German economic strategy – rightly in my view – agrees that it may lead to losses to Germany in case of debtor nations leaving the Euro Area.

(By the way this link by Robert M Wuner has the complete list of articles on the TARGET2 debate).

Now, I have myself written a set of articles on this: The Eurosystem: Part 1Part 2Part 3Part 4, & Part 5.

On the specific issue about creditor nations taking a loss see this post: Who Is Germany and Deutsche Bundesbank’s TARGET2 Claims.

While it is difficult to summarize the whole debate, the point which comes to mind is that while those who have written about the TARGET2 system in a more technically correct way (central bank articles, banks’ research publications, academicians), they are seriously misleading. Some don’t see it while – in my opinion – the Eurosystem authors see it and downplay the risks.

So here’s from Beate’s article:

If the country in question refrains from staying connected to Target2 and, at the same time, is abandoning the ECB – in my understanding (but we must ask the jurists to find out) its paid-up capital will have to be returned plus its share of profit, or minus its share of loss according to a consolidated closing balance sheet and profit and loss statement.

Now this is serious underplay. She concludes:

The way the issue of Target2 balances is discussed in public is most regrettable. The ever new records of unmanageable bilateral debt allegedly heaping up in the system arouse fears which are wholly unreasonable and stand in the way to finding a viable crisis solution. Two points should be kept in mind: Monetary policy matters such as the creation of central bank money must not be confused with the process of payment and settlement of central bank money, and intra-group payment flows as part of the normal business of the system must not be confused with profits and losses.

At closer inspection, the €2 trillion debt scenario conjured up by some observers in an utterly irresponsible way is evaporating into thin air and the euro crisis – although still a very serious problem and a big challenge – appears as one that probably can be handled.

The error in analysis such as this is that of not thinking of “money” as simultaneously as an asset and a liability.

It is best to think of the creditor nations as a whole so that the complication of “capital key” can be avoided. In my post Who Is Germany I argue that the exit of debtor members of the Euro Area will lead to losses for the creditor nations because the debtor nations will not be able to pay the Euro-denominated TARGET2 liabilities. This appears via a direct loss on the central banks’ balance sheet. And since this is a loss of the balance sheet of a nation (or a group of nations as a whole), it is plainly incorrect to argue that it does not matter or that Soros is wrong. The complication of “capital key” is a bit of a sideshow – if Germany’s losses are less than its TARGET2 claims, other NCBs lose. It is true that the Bundesbank may be capitalized by the German government – in case – but no amount of domestic transaction can change the external assets (of Germany as a whole). The fact that it is a loss to Germany can be seen by looking at the International Investment Position. If the Bundebank loses its TARGET claims, it is a loss for the whole nation. As the chapter 7 of the IMF’s Balance Of Payments And International Investment Position Manual (BPM6) says:

The IIP is a subset of the national balance sheet. The net IIP plus the value of nonfinancial assets equals the net worth of the economy, which is the balancing item of the national balance sheet.

In fact, George Soros’ argument is that since exits of debtor nations from the Euro Area will lead to serious losses to creditor nations, this has the effect of forcing the latter – especially Germany – to do something and in fact in leading them to move toward higher integration! (as a title of his recent article The Accidental Empire from Project Syndicate suggests).

To the point of Beate Reszat’s dislike for the phrase – “evaporating in thin air”, the BPM6 and the 2008 SNA use similar terminology – “appearance and disappearance of assets”!