Tag Archives: international investment position

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.


  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”!

Cyprus Seeking Bailout

According to a Wall Street Journal article from yesterday Cyprus Seen Close to a Request for Bailout, Cyprus (2011 GDP: €18bn approximately) is set to become the fourth Euro Area nation to seek a bailout after Greece, Ireland and Portugal. According to the WSJ:

Late last year, the country negotiated a €2.5 billion ($3.1 billion) bilateral loan from Russia. Now, Cyprus is in talks with China for another bilateral loan, of an undisclosed amount, that looks unlikely to materialize in time.

Had to go into trouble considering that economists have been realizing that the Euro Area problems is an internal balance of payments crisis.

The closest proxy for a nation’s net indebtedness is the net international investment position (as opposed to “external debt” which excludes equity held by nonresidents). Here’s the chart as of 2011: the NIIP is at the end of 2011 and the GDP is the gross domestic product for the whole year.

(click to enlarge)

Note: Greece’s NIIP improved in 2011 (from minus 100% of gdp) due to large revaluation losses suffered by foreigners as Greece financial markets fell in 2011.

The financial markets is now nervous about Spain and Slovakia’s next in the line if the graph is to be believed and it’s external position is in dangerous territory also – at minus 64%.

According to Wynne Godley, anything between 20-40% of net foreign indebtedness can be highly dangerous. Of course his models also show that there is nothing intrinsically stopping such imbalances from continuing and can go on as long as foreigners do not mind but something has to give in – such as slower growth to prevent the imbalances from continuing before foreigners start minding or a crash.

At this point, Slovakia doesn’t seem to be in trouble with its generic 10-year government bond yield at 3.645% – with its public debt at 43.3% of gdp at the end of 2011 according to Eurostat. This of course means that the domestic private sector is a net debtor (i.e., its financial assets is lesser than its liabilities). A more detailed analysis is required on how internal imbalances will play out and spill over to the external sector. Here’s from Statistical Appendix of the “Alert Mechanism Report”.

(click to enlarge)

Moving on to something different:

Heteredox Economics In Playboy!

Via Twitter:

John Cochrane of Chicago calls heteredox economists “kooks” and claims he and his colleagues use rigorous models!

The Monetary Economics Of Sovereign Government Rating

If a government (outside monetary unions) can make a draft at the central bank, why do rating agencies rate governments’ creditworthiness?

In this post, I will attempt to describe the dynamics of defaults and restructurings by going through some monetary economics of open economies.

Carmen Reinhart and Kenneth Rogoff wrote a book in 2009 titled This Time Is Different: Eight Centuries Of Financial Folly or simply This Time Is Different arguing that governments do indeed default – both in debt denominated in the domestic and foreign currencies. They blame the public debt and the government for the public debt – hence giving the innuendo that governments across the planet should attempt to cut public debt by tight fiscal policies. This is an illegitimate conclusion – on which I will say more below.

At another extreme are the Chartalists who argue that the government cannot “run out of money” and hence fiscal policy has no monetary constraints. Sometimes they qualify this statement by saying that the currency they are discussing are “sovereign currencies”. Now, there are various definitions of what a sovereign currency is but it is frequently pointed out by them that nations who have seen restructuring of government debt did not have a “sovereign currency” – because the currency is either pegged or fixed or it is the case that the government had a lot of debt in foreign currency which presumably allows defaults/restructuring of government debt in the domestic currency as well. The motivation behind this is Milton Friedman’s idea that nations should freely float their currencies in international markets and that markets will clear and that the State intervention in the currency markets can only make things worse. Hence Reinhart/Rogoff don’t prove them wrong – according to them – since the situations are supposedly different.

We will see that while there is some truth to it, the notion of a “sovereign currency” is highly misleading. Such intuitions are coincident with the incorrect notion that indebtedness to foreigners (in domestic currency) is just a technical liability and there’s nothing more to that!

Here’s S&P’s article on the methodology it uses to assign ratings on governments: Standard & Poor’s – Sovereign Government Rating And Methodology. One can see the importance it gives to the external sector. However, S&P does not provide a mechanism on how a government will finally end up defaulting. The purpose of this post is to look into this.

Before this let us make a connection between the public debt and the net indebtedness of a nation. Most people in the planet confuse the two. The former is the debt of the government whereas the latter is the (net) indebtedness of the nation as a whole. This is the net international investment position (adjusting for traditional settlement assets such as gold) with the sign reversed. This can be obtained by consolidating all the sectors of an economy and the consolidation involves (for example) netting of the assets of the domestic private sector held abroad and also its gross indebtedness to the rest of the world.

So one can think of two extremes:

  1. Japan – with a high public debt of about 195% of gdp (includes just the central government debt),  while being a net creditor of the world. It’s NIIP is about 50% of gdp (data source: IMF)
  2. Australia – with a low public debt of 18% of gdp and NIIP of minus 59% of gdp.

So in the case of Japan, while the government is a huge debtor, the nation as a whole is a creditor, whereas in the case of Australia, it is the opposite. So the rating agencies get it wrong or opposite!

Let us first assume a closed economy. The greatest starting point in analyzing economies is the sectoral balances approach. For a closed economy it is:


where NAFA is the Net Accumulation of Financial Assets of the private sector and DEF is the government’s budget deficit. If the private sector wants to accumulate a lot of financial assets, and the government wants to run the economy near full employment, the public debt will be higher, the higher the propensity to save, for example. (This is not as straightforward as presented here but can be shown in a simple stock-flow consistent model). So unlike what neoclassical economists think, the level of public debt is somewhat irrelevant. Neither does the government has too much trouble in financing its debt because the public debt is the mirror image of the private sector net financial asset position.

Now let us take the case of an open economy. The sectoral balances identity now is


A deficit in the current account implies an increase in the net indebtedness to foreigners. Unless the markets miraculously clear with the exchange rate adjusting to bring the CAB in balance, a deficit in the current account implies the nation as a whole has to attract foreigners to finance this deficit i.e., via a lower NAFA or higher DEF. In the long run, the private sector is accumulating financial assets (or has small positive NAFA) and the whole of the current account balance is reflected in the public sector balance.

So the debate fixed vs floating doesn’t help too much. A relaxation of fiscal policy may spill over into higher imports with the public debt and the net indebtedness to foreigners keeps rising forever to gdp. Hence nations typically have to curb growth to bring the current account into balance.

An excellent reference for this is New Cambridge Macroeconomics And Global Monetarism – Some Issues In The Conduct Of U.K. Economic Policy, 1978, by Martin Fetherston and Wynne Godley.

This is theory. So let’s look at an open economy mechanism of an event of default by the government as a story.

In the following, I will use the phrase “pure float” instead of the dubious terminology “sovereign currency”.

Here’s the simplest model:

In the above, a nation with its currency on a pure float and with zero official sector liabilities in foreign currencies has a somewhat weak external position in 2012. Now, according to some of the Neochartalist arguments this nation can’t default on its government debt. However this is a wrong conclusion as the scenario above hightlights. In the scenario constructed, the balance of payments position weakens over the years (and I have mentioned that roughly in 2020 it weakens). In 2022, foreigners are no longer willing to finance the debt. This may be due to a capital flight or due to the inability of the banking system to maintain a low net open position in foreign currency. The depreciation of the domestic currency isn’t sufficient to clear the fx markets and the official sector (either the central bank or the government’s treasury) necessarily has to intervene in the foreign exchange markets by issuing debt denominated in foreign currency. The government is then acting as the borrower of the last resort and the objective is to use the proceeds to partially have more foreign exchange reserves and/or to sell the foreign currency proceeds from the debt issuance to clear the fx markets. The government is then left with a net liability position in the foreign currency. Soon the external situation worsens to the point requiring official foreign help – such as from the IMF – which promises to help and requires a restructuring of the debt both in domestic and foreign currencies.

Free marketers have a blind belief in the markets and the theories are built on the assumption that markets always clear. The recent crisis has highlighted that this isn’t the case. Even for the case of Australia – whose currency can be considered closed to being pure float – has had issues in the external sector and the Reserve Bank of Australia had to borrow in US dollars from the Federal Reserve (via swap lines) to help Australian banks meet their foreign currency funding needs during the crisis.

Of course the above is not typical but to prevent the external vulnerability to go out of control, governments keep domestic demand low and a lot of times, they over-do this.

The point of the exercise is to prove that it is not meaningless to think of nations becoming bankrupt in whichever situation one can think of and it doesn’t help to laugh at the rating agencies and make fun of them – possibly with the exception for the case of Japan. Statements such as “government with a sovereign currency cannot become bankrupt” are simply misleading. In the above, the Chartalists would argue that the currency was not sovereign and they were not wrong about the default but the currency was sovereign in their own definition in 2012!

Here are some comments on some nations.

Japan: As mentioned above, Japan is a net creditor of the rest of the world and partially as a consequence of that, most of the Japanese government’s debt is held internally. The rating agencies are aware of this but in spite of this continue to make comments on the creditworthiness of the Japanese government. It is possible that residents may transfer funds abroad for unknown reasons (which the raters for some reason suspect) but it may require just a minor interest rate hike to prevent this from happening. Japan has a relatively strong external situation and hence has no issues in financing its government debt.

Canada: Nick Rowe of WCI mentioned to me on his blog that worrying about the balance of payments constraint is like “beating a dead horse” – citing the example of Canada which has floated its currency and it seems has no trouble with its external sector. But this ignores other things in the formulation of the problem. Canada is an advanced nation and an external situation which is not weak. However, a growth of the nation much faster than the rest of the world will lead to a worsening of the external situation. To some extent the nation’s external situation has been the result of its relatively better competitiveness of exporters compared to its propensity to import and a demand situation which either as a conscious attempt of demand management of the government or by pure fluke has helped its external situation remain non-vulnerable.

United States: The US dollar is the reserve currency of the world and slowly over time, the United States has turned from being a creditor of the rest of the world to becoming the world’s largest debtor nation. (Again not due to its public debt but because of its net indebtedness to foreigners). The US external sector is a great imbalance and any attempt to get out of the recession by fiscal policy alone will worsen its external situation leading to a crash at some point. S&P is right! So to come out of the depressed state, the nation has to complement fiscal expansion with improvement of the external situation such as by (and not restricted to) asking trading partners to not revalue their currencies. Still for some reasons bloggers at the “New Economic Perspectives” think that

… Bernanke also knows that the US has infinite ability to finance these fiscal components, that there is no solvency issue and that the policy rate and both ends of the yield curve are under the direct control of the Fed.

Back to This Time Is Different. While Reinhart and Rogoff’s analysis of government debt may be useful, their conclusions can be destructive for the world as a whole. The domestic private sector of a nation needs continuous injection from outside so that it can run surpluses in general and tightening of fiscal policies will lead to a depression. Global imbalances is crucial in understanding the nature of this crisis (and not public debt alone) and even coordinated attempts to reflate economies may provide only a temporary relief. Since failure in international trade restricts the growth of nations and their attempts to reach full employment, what the world needs is an entirely different way to run the economies under managed trade with fiscal expansion. Ideas of “free trade” such as that outlined here by Alan Blinder simply help some classes of society at the expense of others because it relies on the “market mechanism” which has failed over and over again.

This brings me to “sovereignty”. As argued, the concept “sovereign currency” is almost vacuous (except highlighting the problems of the Euro Area) but sovereignty as argued by Wynne Godley in his great 1992 article Maastricht And All That and by Anthony Thirlwall in the same year on FT (my post on it here Martin Wolf Pays A Generous Tribute To Anthony Thirlwall) definitely have great importance. Some of Thirwall’s concepts of economic sovereignty in the article were: the ability to protect and encourage strategic industries, the possibility of designing systems of managed trade to even out payments imbalances, the ability to protect against certain countries with persistent surpluses, differential taxes which discriminate in favour of the tradeable goods sector.

Updated: 5 May 2012 at 11:07am GMT – typos corrected

Exorbitant Privilege

My last post was on U.S. net income payments from abroad and how it continues to be in the favour of the United States. The late Wynne Godley had been analyzing this since 1994. In an article titled U.S. Trade Deficits: The Recovery’s Dark Side?, written with William Milberg, he had a section called “Foreign indebtedness and the foreign income paradox” where he said:

So far, the practical consequences of the United States having become “the world’s largest debtor” have not been all that significant… But it would be an error to suppose that, because the net return on net assets has been negligible in the recent past, the same thing will be true in the future…

… Why did the net foreign income flow remain positive for so long after 1988? In order to understand this apparent paradox, it is essential to disaggregate stocks of assets and liabilities and their associated flows, and to distinguish (in particular) between financial assets and direct investments… The reason that net foreign income remained positive for so long can now be understood (at least up to a point) by making a comparison of the flows shown in Figure 3 with the stocks shown in Figure 2. The net inflow that arises from direct investment has been roughly equal to the net outflow on financial assets in recent years, even though the stock of financial liabilities has been about five times as large as the market value of net foreign investments. In other words, the rate of return on net direct investments far exceeded the rate on net financial liabilities

Figure 2 referred to is below:

and Figure 3:

which is what I redrew with updated data in my previous post. But as we saw the net income payments from abroad continues to be positive (!!) even till date but the reason is similar. Foreign direct investment in the United States has risen to $2.8T at the end of 2011 as per Federal Reserve’s Z.1 Flow of Funds while U.S direct investment abroad rose to $4.8T – significantly higher (even as a percent of GDP) than in the mid-90s.

The net direct investment has seen huge returns (both via income and holding gains) and so this killing has brought in good fortunes for the United States. Of course with the whole current account of balance of payments in deficit, the external sector bleeds the circular flow of national income in the United States and contributes to weak demand there.

So a current account deficit is bad for the United States but financing this deficit has been easy for the United States given that the US Dollar is the reserve currency of the world. Why do nations require reserve assets? The late Joseph Gold of the IMF gave a nice description in his book Legal and Institutional Aspects of the International Monetary System: Selected Essays:

What makes the US dollar the reserve currency of the world is difficult to argue. However it cannot be taken for granted that the United States may enjoy this exorbitant privilege given that the Sterling was once the darling of the financial markets and central banks.

After writing the previous post, I came across this interesting paper From World Banker To World Venture Capitalist – U.S. External Adjustment And The Exorbitant Privilege by Pierre-Olivier Gourinchas and Hélène Rey written in 2005.

Their argument is similar – direct investments have made huge returns for the domestic private sector of the United States and gives a good account of the external sector. Here’s a graph of the United States’ net international investment position using data reported by the Federal Reserve’s Z.1 Flow of Funds Accounts as well as the BEA’s International Investment Position:

Why the difference is a topic for another post. I don’t know it yet. Gourinchas and Rey have some answers. The Federal Reserve’s data is till 2011 end and quarterly (and seasonally adjusted) while BEA data is yearly and available till 2010.

So, from the graph above, the United States became a net debtor of the world around 1986. The indebtedness has been rising mainly due to the huge current account deficits the nation manages to run and is partly offset by “holding gains”.

Here’s a graph of the current account deficit plotted with other “financial balances” (since they are related by an identity)

I also discuss this in my post The Un-Godley Private Sector Deficit.

By the way, the U.S. was a creditor of the world when the Bretton Woods system of fixed exchange rates collapsed. Some authors describe this collapse by saying that money has become fiat since 1971 – whatever that means!

Gourinchas and Rey point out – correctly in my opinion:

The previous discussion points to a possible instability, even in an international monetary system that lacks a formal anchor. The relevant reference here is Triffin’s prescient work on the fundamental instability of the Bretton Woods system (see Triffin 1960). Triffin saw that in a world where the fluctuations in gold supply were dictated by the vagaries of discoveries in South Africa or the destabilizing schemes of Soviet Russia, but in any case unable to grow with world demand for liquidity, the demand for the dollar was bound to eventually exceed the gold reserves of the Federal Reserve. This left the door open for a run on the dollar. Interestingly, the current situation can be seen in a similar light: in a world where the United States can supply the international currency at will and invests it in illiquid assets, it still faces a confidence risk. There could be a run on the dollar not because investors would fear an abandonment of the gold parity, as in the 1970s, but because they would fear a plunge in the dollar exchange rate. In other words, Triffin’s analysis does not have to rely on the gold-dollar parity to be relevant. Gold or not, the specter of the Triffin dilemma may still be haunting us!

Gourinchas and Rey’s arguments depend on estimating a tipping point – the point where the net income payments from abroad turn negative. This of course depends on various assumptions but let us look at it.

The gross assets of the United States held abroad and liabilities to foreigners keep changing as the nation is able to increase its liabilities and use it to make direct investments abroad. The reserve currency status has provided the nation with this privilege as central banks around the world are willing to hold dollar-denominated assets. The positive return (as well as revaluation gains from the depreciation of the dollar – when it depreciates) helps reduce the net indebtedness but the current account deficit contributes to increasing it.

The following is the graph of gross assets and liabilities – using the Federal Reserve’s Z.1 Flow of Funds Accounts data and also BEA’s data for the ratio:

So assuming assets held abroad make a return rand liabilities to foreigners lead to payments at an effective interest rate rincome payments from abroad will turn negative whenever

r· A − r· L < 0

So A and L are changing due to the current account deficits and revaluation gains on assets and liabilities. Meanwhile, the effective interest rates are themselves changing in time because of various things such as short term interest rates set by the central banks, market conditions, state of the economy etc. Also, if the private sector of the United States makes more direct investments abroad, this will contribute to increase rA (if successful) and the process can go on with net income payments from abroad staying positive for longer. The tipping point is defined by Gourinchas and Rey as the ratio L/A beyond which the the net income payments turn negative. According to their analysis (based purely on historical data), this is 1.30.

If the net income payments from abroad turns negative, international financial markets and central banks may start suspecting the future of the exorbitant privilege according to the authors. Of course, it may be the case that even if it turns negative, the United States’ creditors don’t mind – this has been the case of Australia. The following is from the page 18 of the Australian Bureau of Statistics release Balance of Payments and International Investment Position, Australia, Dec 2011 and in their terminology – which is the same as the IMF’s – it is called “net primary income”)

(Australia’s Q4 2011 GDP was around A$369bn for comparison) and the above graph is quarterly.

So, to conclude the process can continue as long as foreigners do not mind. It shouldn’t be forgotten however that Australian banks had funding issues during the financial crisis and the RBA used its line of credit at the Federal Reserve via fx swaps to prevent a run on Australian banks and it is difficult to design policy without keeping in mind the possibility of walking into uncharted territory.

Once net primary income turns negative, the process can quickly run into unsustainable territory due to the magic of compounding of interest unless the currency depreciates in the favour of the nation helping exports. Else demand has to be curtailed to prevent an explosion but this hurts employment. Other policy options include promotion of exports and asking trading partners to increase domestic demand by fiscal expansion.

Updated: 19 March 2012